- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 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
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE
REGISTRANT TITLE OF EACH CLASS ON WHICH REGISTERED
- ---------- ------------------- -------------------
UNISOURCE ENERGY COMMON STOCK, NO PAR VALUE AND New York Stock Exchange
CORPORATION PREFERRED SHARE PURCHASE RIGHTS Pacific Exchange
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: NONE
Indicate by check mark whether each registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of each registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
UniSource Energy Corporation Yes X No
--- ---
Tucson Electric Power Company Yes No X
--- ---
The aggregate market value of UniSource Energy Corporation voting
Common Stock held by non-affiliates of the registrant was $847,469,716 based on
the last reported sale price thereof on the consolidated tape on June 30, 2004.
At March 11, 2005, 34,545,932 shares of UniSource Energy Corporation Common
Stock, no par value (the only class of Common Stock), were outstanding.
At March 11, 2005, 32,139,555 shares of Tucson Electric Power Company's
common stock, no par value, were outstanding, of which 32,139,434 shares were
held by UniSource Energy Corporation.
Documents incorporated by reference: Specified portions of UniSource Energy
Corporation's Proxy Statement relating to the 2005 Annual Meeting of
Shareholders are incorporated by reference into Part III.
- --------------------------------------------------------------------------------
TABLE OF CONTENTS
Definitions v
-- PART I --
Item 1. - Business 1
Overview of Consolidated Business 1
TEP Electric Utility Operations 2
Service Area and Customers 2
Generating and Other Resources 4
Fuel Supply 7
Water Supply 9
Transmission Access 9
Rates and Regulation 11
TEP's Utility Operating Statistics 12
Environmental Matters 13
UNS Gas 14
Service Territory and Customers 14
Gas Supply and Transmission 14
Rates and Regulation 15
UNS Electric 16
Service Territory and Customers 16
Power Supply and Transmission 16
Rates and Regulation 16
Global Solar Energy, Inc. 17
Other 17
Employees 18
SEC Reports Available on UniSource Energy's Website 19
Item 2. - Properties 19
TEP Properties 19
UES Properties 20
Global Solar Properties 21
Item 3. - Legal Proceedings 21
Item 4. - Submission of Matters to a Vote of Security Holders 22
-- PART II --
Item 5. - Market for Registrant's Common Equity, Related
Stockholder Matters, Issuer Purchases of Equity Securities 22
Item 6. - Selected Consolidated Financial Data 23
UniSource Energy 23
TEP 24
Non-GAAP Measures 25
Item 7. - Management's Discussion and Analysis of
Financial Condition and Results of Operations 27
UniSource Energy Consolidated 28
Outlook Strategies 28
Results of Operations 29
Contribution by Business Segment 30
Liquidity and Capital Resources 30
Tucson Electric Power Company 35
Results of Operations 36
Factors Affecting Results of Operations 39
Liquidity and Capital Resources 42
UNS Gas 49
Results of Operations 49
ii
Factors Affecting Results of Operations 50
Liquidity and Capital Resources 50
UNS Electric 52
Results of Operations 52
Factors Affecting Results of Operations 53
Liquidity and Capital Resources 54
Global Solar Energy, Inc. 55
Results of Operations 55
Other 56
Results of Operations 56
Critical Accounting Estimates 58
New Accounting Pronouncements 64
Safe Harbor for Forward-Looking Statements 65
Item 7A. - Quantitative and Qualitative Disclosures about Market Risk 66
Item 8. - Consolidated Financial Statements and Supplementary Data 69
Management's Report on Internal Controls Over Financial
Reporting Under Section 404 of Sarbanes-Oxley 69
Reports of Independent Registered Public Accounting Firm 70
UniSource Energy Corporation
Consolidated Statements of Income 72
Consolidated Statements of Cash Flows 73
Consolidated Balance Sheets 74
Consolidated Statements of Capitalization 75
Consolidated Statements of Changes in Stockholders' Equity 76
Tucson Electric Power Company
Consolidated Statements of Income 77
Consolidated Statements of Cash Flows 78
Consolidated Balance Sheets 79
Consolidated Statements of Capitalization 80
Consolidated Statements of Changes in Stockholders' Equity 81
Notes to Consolidated Financial Statements
Note 1. Nature of Operations and Summary of Significant
Accounting Policies 82
Note 2. Termination of Proposed Acquisition of UniSource Energy 102
Note 3. UniSource Energy Services 102
Note 4. TEP Regulatory Matters 105
Note 5. Accounting Change: Accounting for Asset
Retirement Obligations 109
Note 6. Segment and Related Information 111
Note 7. Accounting for Derivative Instruments, Trading
Activities and Hedging Activities 113
Note 8. Commitments and Contingencies 115
Note 9. Utility Plant and Jointly-Owned Facilities 121
Note 10. Debt and Capital Lease Obligations 123
Note 11. Fair Value of Financial Instruments 126
Note 12. Stockholders' Equity 127
Note 13. TEP Wholesale Accounts Receivable and Allowances 129
Note 14. Springerville Expansion 129
Note 15. Income and Other Taxes 130
Note 16. Employee Benefit Plans 133
Note 17. Stock-Based Compensation Plans 137
Note 18. UniSource Energy Earnings Per Share 139
Note 19. Related Parties 139
Note 20. Supplemental Cash Flow Information 141
Note 21. Quarterly Financial Data (Unaudited) 143
Schedule II - Valuation and Qualifying Accounts 145
Item 9. - Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 147
Item 9A. - Controls and Procedures 147
iii
Item 9B. - Other Information 147
-- PART III --
Item 10. - Directors and Executive Officers of the Registrants 147
Item 11. - Executive Compensation 149
Item 12. - Security Ownership of Certain Beneficial Owners and Management 150
Item 13. - Certain Relationships and Related Transactions 150
Item 14. - Principal Accountant Fees and Services 150
-- PART IV --
Item 15. - Exhibits and Financial Statements Schedules 151
Signatures 152
Exhibit Index 156
iv
DEFINITIONS
The abbreviations and acronyms used in the 2004 Form 10-K are defined below:
- --------------------------------------------------------------------------------
ACC................................. Arizona Corporation Commission.
ACC Holding Company Order........... The order approved by the ACC in
November 1997 allowing TEP to
form a holding company.
AHMSA............................... Altos Hornos de Mexico, S.A.
de C.V. AHMSA owns 50% of Sabinas.
AMT................................. Alternative Minimum Tax.
APS................................. Arizona Public Service Company.
Btu................................. British thermal unit(s).
Capacity............................ The ability to produce power; the most
power a unit can produce or the
maximum that can be taken under a
contract; measured in MWs.
CISO................................ California Independent System
Operator.
Citizens............................ Citizens Communications Company.
Citizens Settlement Agreement....... An agreement with the ACC Staff
dated April 1, 2003, addressing
rate case and financing issues
in the acquisition by UniSource
Energy of the Citizens' Arizona gas
and electric assets.
Common Stock........................ UniSource Energy's common stock,
without par value.
Company or UniSource Energy......... UniSource Energy Corporation.
Cooling Degree Days................. An index used to measure the impact
of weather on energy usage
calculated by subtracting 75
from the average of the high
and low daily temperatures.
CPX................................. California Power Exchange.
Credit Agreement.................... Credit Agreement between TEP and a
syndicate of banks, dated as of
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.
EPA................................. The Environmental Protection Agency.
ESP................................. Energy Service Provider.
Express Line........................ 345-kV circuit connecting
Springerville Unit 2 to the Tucson
138-kV system.
FAS 71.............................. Statement of Financial Accounting
Standards No. 71: Accounting for
the Effects of Certain Types of
Regulation.
FAS 133............................. Statement of Financial Accounting
Standards No 133: Accounting for
Derivative Instruments and Hedging
Activities, as amended.
FAS 143............................. Statement of Financial Accounting
Standards No. 143: Accounting for
Asset Retirement Obligations.
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 J.P. Morgan Chase
Bank, successor trustee, as
supplemented and amended.
Four Corners........................ Four Corners Generating Station.
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.
v
IRS................................. Internal Revenue Service.
ISO................................. Independent System Operator.
ITC................................. Investment Tax Credit.
kWh................................. Kilowatt-hour(s).
kV.................................. Kilovolt(s).
LIBOR............................... London Interbank Offered Rate.
LOC................................. Letter of Credit.
Luna................................ Luna Energy Facility.
MEG................................. Millennium Environment 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.
PNMR................................ PNM Resources.
Powertrusion........................ POWERTRUSION International, Inc.,
a company owned 77% by
Millennium, which manufactures
lightweight utility poles.
PPFAC............................... Purchased Power and Fuel Adjustment
Clause.
PWCC................................ Pinnacle West Capital Corporation.
Revolving Credit Facility........... $60 million revolving credit facility
entered into under the Credit
Agreement between a syndicate of
banks and TEP.
RTO................................. Regional Transmission Organization.
Rules............................... Retail Electric Competition Rules.
Sabinas............................. Carboelectrica Sabinas,
S. de R.L. de C.V., a Mexican
limited liability company.
Millennium owns 50% of Sabinas.
Saguaro Utility..................... An Arizona limited partnership, whose
general partner is Sage
Mountain, L.L.C. and whose limited
partners include investment
funds affiliated with Kohlberg
Kravis Roberts & Co., L.P.,
J.P. Morgan Partners, L.L.C. and
Wachovia Capital Partners.
San Carlos.......................... San Carlos Resources Inc.,
a wholly-owned subsidiary of TEP.
San Juan............................ San Juan Generating Station.
Second Mortgage Bonds............... TEP's second mortgage bonds issued
under the Indenture of Mortgage
and Deed of Trust, dated as of
December 1, 1992, of TEP to the Bank
of New York, successor trustee, as
supplemented.
Sempra.............................. Sempra Energy Trading Company.
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.
vi
Springerville Unit 1................ Unit 1 of the Springerville
Generating Station.
Springerville Unit 1 Lease.......... Leveraged lease arrangement relating
to Springerville Unit 1 and an
undivided one-half interest in
certain Springerville Common
Facilities.
Springerville Unit 2................ Unit 2 of the Springerville
Generating Station.
SRP................................. Salt River Project Agricultural
Improvement and Power District.
Sundt............................... H. Wilson Sundt Generating Station
(formerly known as the Irvington
Generating Station).
Sundt Lease......................... The leveraged lease arrangement
relating to Sundt Unit 4.
SWG................................. Southwest Gas Corporation.
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.
Valencia............................ Valencia power plant owned by UNS
Electric.
WestConnect......................... The proposed for-profit RTO in
which TEP is a participant.
vii
PART I
This Annual Report on Form 10-K contains forward-looking statements as
defined by the Private Securities Litigation Reform Act of 1995. You should read
forward-looking statements together with the cautionary statements and important
factors included in this Form 10-K. (See Item 7. - Management's Discussion and
Analysis of Financial Condition and Results of Operations, Safe Harbor for
Forward-Looking Statements). Forward-looking statements include statements
concerning plans, objectives, goals, strategies, future events or performance
and underlying assumptions. Forward-looking statements are not statements of
historical facts. Forward-looking statements may be identified by the use of
words such as "anticipates," "estimates," "expects," "intends," "plans,"
"predicts," "projects," and similar expressions. We express our expectations,
beliefs and projections in good faith and believe them to have a reasonable
basis. However, we make no assurances that management's expectations, beliefs or
projections will be achieved or accomplished. 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.
ITEM 1. - BUSINESS
- --------------------------------------------------------------------------------
OVERVIEW OF CONSOLIDATED BUSINESS
- ---------------------------------
UniSource Energy is a holding company that has no significant operations of
its own. Operations are conducted by UniSource Energy's subsidiaries, each of
which is a separate legal entity with its own assets and liabilities. UniSource
Energy owns substantially all of the outstanding common stock of 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 began operations in August 2003. UES
through its two operating subsidiaries, UNS Gas and UNS Electric, provides gas
and electric service to 30 communities in northern and southern Arizona.
Millennium invests in unregulated businesses, including Global Solar Energy
(Global Solar), a developer and manufacturer of thin-film photovoltaic cells and
modules. UED engages in developing generating resources and other project
development activities, including facilitating the expansion of the
Springerville Generating Station, but has no significant operations. We conduct
our business in four primary business segments - TEP's Electric Utility segment,
UNS Gas, UNS Electric and Global Solar.
UniSource Energy was incorporated in the State of Arizona on March 8, 1995
and obtained regulatory approval to form a holding company in November 1997. On
January 1, 1998, TEP and UniSource Energy exchanged shares of stock resulting in
TEP becoming a subsidiary of UniSource Energy. Following the share exchange, TEP
transferred the stock of its subsidiary Millennium to UniSource Energy. See Note
10 of Notes to Consolidated Financial Statements - Debt and Capital Lease
Obligations.
TERMINATION OF MERGER AGREEMENT
In November 2003, UniSource Energy entered into an Agreement and Plan of
Merger (the Agreement) with Saguaro Acquisition Corp. (Saguaro), an affiliate of
Saguaro Utility Group L.P. (Saguaro LP) that provided for the acquisition of all
of UniSource Energy's outstanding common stock for $25.25 per share by Saguaro.
Saguaro LP was an Arizona limited partnership whose general partner was Sage
Mountain, L.L.C. and whose limited partners included investment funds associated
with Kohlberg Kravis Roberts & Co., L.P., J.P. Morgan Partners, LLC and Wachovia
Capital Partners.
On December 21, 2004, the Arizona Corporation Commission (ACC) voted, at
the end of a special open meeting, not to approve the application seeking its
approval of the proposed acquisition.
The Agreement provided that in the event that the ACC denied the
acquisition, Saguaro or UniSource Energy could terminate the Agreement, and
UniSource Energy would be obligated to reimburse up to $7 million of Saguaro's
expenses. On December 30, 2004, Saguaro exercised its right to terminate the
Agreement and UniSource Energy paid Saguaro $7 million to cover Saguaro's
expenses, pursuant to the terms of the Agreement.
BUSINESS SEGMENT CONTRIBUTIONS
K-1
The table below shows the contributions to our consolidated after-tax
earnings by our four business segments.
2004 2003 2002
-------------------------------- -------------- ---------------- --------------
-Millions of Dollars-
BUSINESS SEGMENT
TEP (1) $ 46 $ 129 $ 55
UNS Gas (2) 6 1 -
UNS Electric (2) 4 2 -
Global Solar (5) (7) (14)
Other (3) (5) (11) (6)
-------------------------------- -------------- ---------------- --------------
Consolidated Net Income $ 46 $ 114 $ 35
================================ ============== ================ ==============
(1) TEP results in 2003 include an after-tax gain of $67 million for the
Cumulative Effect of Accounting Change from the adoption of Statement of
Financial Accounting Standards No. 143, Accounting for Asset Retirement
Obligations (FAS 143).
(2) 2003 results are for the period from August 11, 2003 to December 31,
2003.
(3) Includes: interest expense (net of tax) on the note that was payable
from UniSource Energy to TEP; costs in 2003 associated with the Citizens
acquisition; costs associated with the failed acquisition of UniSource
Energy as previously discussed; UniSource Energy parent company expenses;
income and losses from Millennium's investments other than Global Solar;
income and losses from UED.
The electric utility industry has undergone significant regulatory change
in recent years. See Item 7. - Management's Discussion and Analysis of Financial
Condition and Results of operations, Outlook and Strategies, for a discussion of
our plans and strategies to remain competitive and flexible in this changing
environment and Rates and Regulation, below, for the status of competition in
Arizona.
References in this report to "we" and "our" are to UniSource Energy and its
subsidiaries, collectively.
TEP ELECTRIC UTILITY OPERATIONS
- -------------------------------
TEP was incorporated in the State of Arizona on December 16, 1963. TEP is
the successor by merger as of February 20, 1964, to a Colorado corporation that
was incorporated on January 25, 1902. TEP is the principal operating subsidiary
of UniSource Energy. In 2004, TEP's electric utility operations contributed 76%
of UniSource Energy's operating revenues and comprised 84% of its assets.
SERVICE AREA AND CUSTOMERS
TEP is a vertically integrated utility that provides regulated electric
service to more than 375,000 retail customers in Southeastern Arizona. TEP's
service territory consists of a 1,155 square mile area and includes a population
of approximately 931,000 in the greater Tucson metropolitan area in Pima County,
as well as parts of Cochise County. TEP holds a franchise to provide electric
distribution service to customers in the Cities of Tucson and South Tucson.
These franchises expire in 2026 and 2017, respectively. TEP also sells
electricity to other utilities and power marketing entities in the western U.S.
RETAIL CUSTOMERS
In 2004, TEP's number of retail customers increased by 2.3% and total
retail energy consumption increased by approximately 3.2%. The table below shows
the percentage distribution of TEP's energy sales by major customer class over
the last three years.
2004 2003 2002
---------------------------- --------------- ---------------- ----------------
Residential 40% 41% 40%
Commercial 21% 20% 20%
Non-mining Industrial 26% 27% 28%
Mining 10% 9% 9%
Public Authority 3% 3% 3%
---------------------------- --------------- ---------------- ----------------
K-2
TEP expects that its peak demand, number of retail customers and retail
energy consumption will increase 2 - 3% annually through 2008. The retail energy
consumption by customer class through 2008 is expected to be similar to the 2004
distribution.
Beginning January 1, 2001, all of TEP's retail customers were eligible to
choose alternative energy providers. Continued regulatory developments and legal
challenges to the retail electric competition rules have raised uncertainty
about the status and pace of retail competition in Arizona. Even though some of
TEP's retail customers may choose other energy providers, the forecasted
customer growth rates referred to above would continue to apply to its
distribution business. At March 11, 2005, none of TEP's customers are being
served by an alternative energy provider. See Rates and Regulation, State,
below.
SALES TO LARGE INDUSTRIAL CUSTOMERS
TEP provides electric utility service to a diverse group of commercial,
industrial, and public sector customers. Major industries served include copper
mining, cement manufacturing, defense, health care, education, military bases
and other governmental entities. Local, regional, and national economic factors
can impact the financial condition and operations of TEP's large industrial
customers. Such economic conditions may directly impact energy consumption by
large industrial customers, and may indirectly impact residential and small
commercial sales and revenues if employment levels and consumer spending are
affected.
Two of TEP's largest retail customers are in the copper mining industry.
TEP has contracts with its two mining customers to provide electric service at
negotiated rates. These contracts expire in 2006 and 2008. TEP's sales to mining
customers depend on a variety of factors including changes in supply and demand
in the world copper market and the economics of self-generation. Average U.S.
copper prices have ranged between $0.63 and $1.46 per pound during the last five
years. As a result of low copper prices in 2002 and 2003, TEP's mining customers
reduced operations during those years and correspondingly reduced energy
consumption. Since October 2003, U.S. copper prices have risen steadily and
averaged approximately $1.47 per pound in February 2005. Higher copper prices
have led to increased mining operations and kWh sales to TEP's mining customers.
WHOLESALE BUSINESS
TEP's electric utility operations include the wholesale marketing of
electricity to other utilities and power marketers. Wholesale sales transactions
are made on both a firm and interruptible basis. A firm basis means that
contractually, TEP must supply the power (except under limited emergency
circumstances), while an interruptible basis means that TEP may stop supplying
power under defined conditions. See Other Purchases and Interconnections, below.
TEP typically uses its own generation to serve the requirements of its
retail and long-term wholesale customers. Generally, TEP commits to future sales
based on expected excess generating capability, forward prices and generation
costs, using a diversified portfolio approach to provide a balance between
long-term, and mid-term and spot energy sales. When TEP expects to have excess
generating capacity and energy (usually in the first, second and fourth calendar
quarters), its wholesale sales consist primarily of three types of sales:
(1) Sales under long-term contracts for periods of more than one year. TEP
currently has long-term contracts with three entities to sell firm
capacity and energy: Salt River Project Agricultural Improvement and
Power District (SRP), which expires in May 2011, the Navajo Tribal
Utility Authority, which expires in December 2009, and the Tohono
O'odham Utility Authority, which expires in August 2009. TEP also has
a multi-year interruptible contract with Phelps Dodge Energy Services,
which expires in February 2006 and requires a fixed contract demand of
60 MW at all times except during TEP's peak customer energy demand
period, from July through September of each year. Under the contract,
TEP can interrupt delivery of power if TEP experiences significant
loss of any electric generating resources.
(2) Other sales include forward sales and short-term sales. Under forward
contracts, TEP commits to sell a specified amount of capacity or
energy at a specified price over a given period of time, typically for
one-month, three-month or one-year periods. Under short-term sales,
TEP sells energy in the daily or hourly markets at fluctuating spot
market prices and makes other non-firm energy sales.
(3) Sales of transmission service.
K-3
TEP purchases power in the wholesale markets when economic. TEP may enter
into forward contracts: (a) to purchase energy under long-term contracts to
serve retail load and long-term wholesale contracts, (b) to purchase capacity or
energy during periods of planned outages or for peak summer load conditions, and
(c) to purchase energy to resell to certain wholesale customers under load and
resource management agreements. Finally, TEP may purchase energy in the daily
and hourly markets to meet higher than anticipated demands, to cover unplanned
generation outages, or when it is more economical than generating its own
energy.
In 2003, both the natural gas and western U.S. wholesale electricity
markets experienced some price spikes and volatility due to severe winter
weather. Gas and power prices remained high throughout 2004 due to continued gas
production and storage concerns. TEP cannot predict, however, whether gas and
wholesale electricity prices will remain elevated and what the impact will be on
TEP's sales and revenues in the future.
TEP expects to continue to be a participant in the wholesale energy
markets, primarily by making sales and purchases in the short-term and forward
markets. TEP expects the market price in the western U.S. and demand for
capacity and energy to continue to be influenced by the following factors, among
others, during the next few years:
o continued population growth;
o economic conditions in the western U.S.;
o availability of generation capacity throughout the western U.S.;
o the extent of electric utility 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 the availability of hydropower;
o transmission constraints; and
o environmental requirements and the cost of compliance.
See Item 7. - Management's Discussion and Analysis of Financial Condition
and Results of Operations, Tucson Electric Power Company, Factors Affecting
Results of Operations, Western Energy Markets, for additional discussion of
TEP's wholesale marketing activities.
GENERATING AND OTHER RESOURCES
TEP GENERATING RESOURCES
At December 31, 2004, TEP owned or leased 2,004 MW of net generating
capability as set forth in the following table:
NET
UNIT FUEL OWNED/ CAPABILITY OPERATING TEP'S SHARE
GENERATING SOURCE NO. LOCATION TYPE LEASED MW AGENT % MW
- -----------------------------------------------------------------------------------------------------------------------------------
Springerville Station 1 Springerville, AZ Coal Leased 380 TEP 100.0 380
Springerville Station 2 Springerville, AZ Coal Owned 380 TEP 100.0 380
San Juan Station 1 Farmington, NM Coal Owned 327 PNM 50.0 164
San Juan Station 2 Farmington, NM Coal Owned 316 PNM 50.0 158
Navajo Station 1 Page, AZ Coal Owned 750 SRP 7.5 56
Navajo Station 2 Page, AZ Coal Owned 750 SRP 7.5 56
Navajo Station 3 Page, AZ Coal Owned 750 SRP 7.5 56
Four Corners Station 4 Farmington, NM Coal Owned 784 APS 7.0 55
Four Corners Station 5 Farmington, NM Coal Owned 784 APS 7.0 55
Sundt Station 1 Tucson, AZ Gas/Oil Owned 81 TEP 100.0 81
Sundt Station 2 Tucson, AZ Gas/Oil Owned 81 TEP 100.0 81
Sundt Station 3 Tucson, AZ Gas/Oil Owned 104 TEP 100.0 104
Sundt Station 4 Tucson, AZ Coal/Gas Leased 156 TEP 100.0 156
Internal Combustion Turbines Tucson, AZ Gas/Oil Owned 122 TEP 100.0 122
Internal Combustion Turbines Tucson, AZ Gas Owned 95 TEP 100.0 95
Solar Electric Generation Springerville/ Solar Owned 5 TEP 100.0 5
Tucson, AZ
- -----------------------------------------------------------------------------------------------------------------------------------
Total TEP Capacity (1) 2,004
===================================================================================================================================
K-4
(1) Excludes 454 MW of additional resources, which consist of certain capacity
purchases and interruptible retail load. At December 31, 2004, total owned
capacity was 1,468 MW and leased capacity was 536 MW.
The Springerville Generating Station, located in northeast Arizona,
consists of two coal-fired units. Springerville Unit 1 began commercial
operation in 1985 and is leased and operated by TEP. Springerville Unit 2
started commercial operation in June 1990 and is owned by TEP's wholly-owned
subsidiary, San Carlos Resources Inc. (San Carlos), and operated by TEP. These
units are rated at 380 MW for continuous operation. The Springerville Station
was originally designed for four generating units. Unit 3 will be 100% leased by
a financial owner to Tri-State Generation and Transmission Association
(Tri-State). Construction of Unit 3 began in October 2003. We expect commercial
operation of Unit 3 to occur in the third quarter of 2006. TEP will operate the
unit. Salt River Project (SRP) has the right to construct and own Unit 4 at a
later date. See UniSource Energy Development Company, below.
The Springerville Generating Station also includes the Springerville Coal
Handling Facilities and the Springerville Common Facilities. In 1984, TEP sold
and leased back the Springerville Coal Handling Facilities. In 1985, TEP sold
and leased back a 50% interest in the Springerville Common Facilities. The other
50% interest is included in the Springerville Unit 1 leases.
TEP obtains approximately 600 MW, or 30% of its generating capacity from
jointly-owned facilities at the San Juan, Four Corners, and Navajo Generating
Stations in New Mexico and northern Arizona.
The Sundt Generating Station (Sundt) includes four units located in Tucson,
Arizona. Units 1, 2 and 3 are gas or oil burning units. Sundt Unit 4 operates
primarily on coal in combination with natural gas or landfill gas, but it is
also able to operate solely on natural gas. Units 1, 2, and 3 are wholly-owned
by TEP, and Unit 4 is leased. The Sundt Generating Station and the internal
combustion turbines located in Tucson are designated as "must-run generation"
facilities. Must-run generation units are those which are required to run in
certain circumstances to maintain distribution system reliability and meet local
load requirements.
See Note 10 of Notes to consolidated Financial Statements, and Item 7. -
Management's Discussion and Analysis of Financial Condition and Results of
Operations, Tucson Electric Power Company, Liquidity and Capital Resources,
Contractual Obligations, for more information regarding the Springerville and
Sundt leases.
POWER EXCHANGE AGREEMENTS
TEP and Southern California Edison Company (SCE) have a power exchange
agreement which expires on May 14, 2005. The agreement required SCE to provide
firm system capacity of 110 MW to TEP during the summer months and for TEP to
return to SCE in the winter months the same amount of energy that TEP received
during the preceding summer. The net incremental increase in cost due to the
loss of the SCE exchange agreement is expected to be less than $2 million
annually.
On January 28, 2005, TEP entered into an exchange agreement with Sempra
Energy Trading Company (Sempra). TEP will provide firm system capacity of 40 MW
to Sempra during February through May 2005. Sempra will then provide TEP with
firm system capacity of 50 MW during June through September 2005.
OTHER PURCHASES AND INTERCONNECTIONS
TEP purchases additional electric energy from other utilities and power
marketers. The amount of energy purchased varies substantially from time to time
depending on the demand for energy, the cost of purchased energy compared with
TEP's cost of generation and the availability of such energy. TEP may also sell
electric energy in the wholesale market.
In 2003, as part of the ACC's Track B competitive energy bidding process,
TEP entered into two power purchase agreements for the period 2003 through 2006
as listed below:
o PPL Energy Plus, LLC supplied 37 MW from June 2003 through December
2003 and supplies 75 MW from January 2004 through December 2006, under
a unit contingent contract between TEP and PPL Energy Plus, LLC.
o Panda Gila River generating station supplies 50 MW on-peak for the
June through September time period, from 2003 (which has been
supplied) through 2005, under a unit contingent contract between TEP
and Panda Gila River, L.P.
K-5
In January 2005, TEP entered into a separate supply agreement with Panda
Gila River. TEP will purchase 50 MW of firm energy during June through September
2005.
TEP is a member of various regional reserve sharing, reliability and power
sharing organizations. These relationships allow TEP to call upon other
utilities during emergencies such as plant outages and system disturbances, and
reduce the amount of reserves TEP is required to carry.
We believe these and other short-term purchases will provide adequate
reserve margins during the summer peak period. See also Wholesale Business,
above and Item 7. - Management's Discussion and Analysis of Financial Condition
and Results of Operations, Tucson Electric Power Company, Factors Affecting
Results of Operations, below.
PEAK DEMAND AND RESOURCES
PEAK DEMAND 2004 2003 2002 2001 2000
-------------------------------------------------------------------
-MW-
Retail Customers - Net One Hour 2,088 2,060 1,899 1,840 1,862
Firm Sales to Other Utilities 187 171 228 151 143
- ------------------------------------------------------------------------------------------------------------------------------------
Coincident Peak Demand (A) 2,275 2,231 2,127 1,991 2,005
Total Generating Resources 2,004 2,003 2,002 1,999 1,904
Other Resources (1) 454 486 308 217 248
- ------------------------------------------------------------------------------------------------------------------------------------
Total TEP Resources (B) 2,458 2,489 2,310 2,216 2,152
Total Margin (B) - (A) 183 258 183 225 147
Reserve Margin (% of Coincident Peak Demand) 8% 12% 9% 11% 7%
- ------------------------------------------------------------------------------------------------------------------------------------
(1) Other Resources include firm power purchases and interruptible retail and
wholesale loads.
TEP's retail sales are influenced by several factors, including seasonal
weather patterns, competitive conditions and the overall economic climate. The
peak demand occurs during the summer months due to the cooling requirements of
TEP's retail customers. Retail peak demand has grown at an average annual rate
of approximately 3% from 2000 to 2004.
The chart above shows the relationship over a five-year period between
TEP's peak demand and its energy resources. TEP's margin is the difference
between total energy resources and coincident peak demand, and the reserve
margin is the ratio of margin to coincident peak demand. TEP maintains a minimum
reserve margin in excess of 7% to comply with reliability criteria set forth by
the Western Electricity Coordinating Council (WECC, formerly the Western Systems
Coordinating Council). TEP's actual reserve margin in 2004 was 8%.
Forecasted retail peak demand for 2005 is approximately 2,144 MW, compared
with actual peak demand of 2,088 MW in 2004. Except for certain peak hours
during the summer, TEP believes it has sufficient resources to meet expected
demand in 2005 with its existing generation capacity and power purchase
agreements.
FUTURE GENERATING RESOURCES -- TEP
In the past, TEP assessed its need for future generating resources based on
the premise of a continued regulatory requirement to serve customers in TEP's
retail service area. However, the ACC's electric competition rules modified the
obligation to provide generation services to all customers. These rules and
TEP's ability to retain and attract customers will affect the need for future
resources. For those customers who do not choose other energy providers, TEP
remains obligated to supply energy. However, TEP is not obligated to supply this
energy from TEP-owned generating assets. The energy may be acquired through
purchases in the wholesale markets. Continued regulatory developments and a
recent Arizona Court of Appeals decision invalidating certain portions of the
ACC rules on retail competition and related market pricing, have raised
uncertainty about the status and pace of retail competition in Arizona. See
Rates and Regulation, Recent Arizona Court of Appeals Decision below and Item 7.
- - Management's Discussion and Analysis of Financial Condition and Results of
Operations, Tucson Electric Power Company, Factors Affecting Results of
Operations, Competition, below.
K-6
LUNA ENERGY FACILITY
On November 12, 2004, TEP, Phelps Dodge Energy Services, LLC and PNM
Resources, Inc. (PNMR) each purchased from Duke Energy North America, LLC a
one-third interest in a limited liability company which owned the partially
constructed natural gas-fired Luna Energy Facility (Luna). In February 2005,
most of the assets of the limited liability company were transferred to the new
owners so that each owner directly owns a one-third interest in the plant. Luna,
located in southern New Mexico, is designed as a 570-MW combined cycle plant and
is expected to be operational by the summer of 2006. Luna is expected to provide
TEP with 190 MW of power to serve its wholesale and retail customers. Public
Service Company of New Mexico, an affiliate of PNMR, will oversee the completion
of construction of Luna, which is approximately 50 percent complete, and will
operate Luna.
TEP paid $13 million for its one-third interest. TEP expects to spend up to
an additional $33 million for its one-third share of the costs to complete
construction of Luna and purchase necessary inventory items, of which $30
million will be spent in 2005 and the remainder in 2006. In addition, TEP
expects to spend $3 million for its share of the capital expenditures related to
an anticipated outage in 2009. TEP anticipates that internal cash flows will
fund its share of the costs related to the plant.
PEAKING RESOURCES
TEP will continue to add peaking resources in the Tucson area as needed
based upon our forecasts of retail and firm wholesale load, as well as the
statewide transmission infrastructure. TEP currently forecasts that additional
peaking resources of 150 MW may be needed in both 2010 and 2013.
SPRINGERVILLE UNIT 3
In conjunction with the expansion of the Springerville Generating Station,
TEP entered into a power purchase contract with Tri-State for up to 100 MW of
capacity from Tri-State's system resources. This contract with Tri-State is for
up to five years, beginning with commercial operation of Unit 3, expected in the
third quarter of 2006. TEP anticipates that any power purchased under this
contract will be sold in the wholesale markets.
FUEL SUPPLY
TEP purchases coal and natural gas in the normal course of business to fuel
its generating plants. The majority of its coal supplies are purchased under
long-term contracts, which result in more predictable prices.
Fuel information is provided below on a delivered to the boiler basis:
AVERAGE COST PER MMBTU PERCENTAGE OF TOTAL BTU
CONSUMED CONSUMED
- -------------------------------------------------------------------------------
2004 2003 2002 | 2004 2003 2002
|
Coal (A) $ 1.57 $ 1.58 $ 1.59 | 96% 96% 94%
Gas $ 6.75 $ 6.38 $ 4.28 | 4% 4% 6%
All Fuels $ 1.79 $ 1.79 $ 1.76 | 100% 100% 100%
- -------------------------------------------------------------------------------
(A) The average cost per ton of coal for 2004, 2003, and 2002 was $30.20,
$30.31, and $30.86, respectively.
TEP'S COAL AND GAS SUPPLY
TEP's principal fuel for electric generation is low-sulfur, bituminous or
sub-bituminous coal from mines in Arizona, New Mexico and Colorado. Four
Corners, Navajo and San Juan Stations are mine mouth generating stations located
adjacent to the coal reserves. The coal supply for Springerville requires
approximately 200 miles of railroad transportation, while the coal supply for
Sundt is approximately 1,300 miles away. All of the contracts for coal and rail
contain price adjustment provisions that are expected to increase the prices at
a rate less than the expected growth of inflation.
Year Average
Contract Sulfur
Station Coal Supplier Terminates Content Coal Obtained From (A)
- ----------------------------------------------------------------------------------------------------------
Springerville Peabody Coalsales Company 2020 0.9% Lee Ranch Coal Company
Four Corners BHP Billiton 2016 0.8% Navajo Indian Tribe
San Juan San Juan Coal Company 2017 0.8% Federal and State Agencies
Navajo Peabody Coalsales Company 2011 0.6% Navajo and Hopi Indian Tribes
Sundt Various approved suppliers 2006 - Various locations
- ----------------------------------------------------------------------------------------------------------
K-7
(A) Substantially all of the suppliers' mining leases extend at least as long as
coal is being mined in economic quantities.
TEP OPERATED GENERATING FACILITIES
TEP is the sole owner (or lessee) and operator of the Springerville and
Sundt Unit 4 Generating Stations. The coal supplies for these plants are
transported from northwestern New Mexico and Colorado by railroad.
In October 2003, TEP amended and extended the long-term coal supply
contract for Springerville Units 1 and 2 through 2020. TEP expects coal reserves
to be sufficient to supply the estimated requirements for Units 1 and 2 for
their presently estimated remaining lives. During the extension period of 2011
through 2020, the coal price will be determined by the cost of Powder River Coal
delivered to Springerville for Unit 3. TEP estimates future minimum annual
payments under this contract to be $45 million through 2010, the initial
contract expiration date, and $14 million from 2011 through 2020. TEP's coal
transportation contract at Springerville runs through 2011. TEP estimates
minimum annual payments under this contract to be $13 million through 2010 and
$7 million in 2011.
In the fourth quarter of 2003, TEP entered into agreements for the purchase
and transportation of coal to Sundt Unit 4 through 2006. The total amount paid
under these agreements depends on the number of tons of coal purchased and
transported. The coal purchase agreement requires TEP to take 335,000 tons
annually with estimated future minimum payments of $6 million in each of 2005
and 2006. The rail agreement requires TEP to transport 325,000 tons with
estimated future minimum payments of $3 million in each year through 2006.
The long-term BNSF rail contract for Sundt Unit 4 is in effect until the
earliest of 2015 or the remaining life of Unit 4. This rail contract requires
TEP to transport at least 75,000 tons of coal per year through 2015 at an
estimated annual cost of $2 million or to make a minimum payment of $1 million.
TEP expects to use the rail contracts for at least the minimum delivery amounts
through at least 2006. See Item 7. - Management's Discussion and Analysis of
Financial Condition and Results of Operations, UniSource Energy Consolidated,
Contractual Obligations and Note 8 of Notes to Consolidated Financial Statements
- - Commitments and Contingencies, TEP Commitments, Purchase and Transportation
Commitments.
GENERATING FACILITIES OPERATED BY OTHERS
TEP also participates in jointly-owned generating facilities at Four
Corners, Navajo and San Juan, where coal supplies are under long-term contracts
administered by the operating agents. In July 2003, the Four Corners coal
contract was extended through July 2016. This contract requires TEP to purchase
minimum amounts of coal at an estimated annual cost of $5 million for the next
13 years. TEP expects coal reserves available to these three jointly-owned
generating facilities to be sufficient for the remaining lives of the stations.
In September 2000, TEP terminated the San Juan Generating Station's coal
supply contract and entered into a new coal supply contract, replacing two
surface mining operations with one underground operation. San Juan Coal Company,
the coal supplier to San Juan, commenced development of the underground mine in
the fourth quarter of 2000. The underground mine did not achieve full station
supply until December 2003 due to geological issues. PNM, TEP and San Juan Coal
Company have begun a review of long term coal cost projections given the
production issues encountered and the experience gained from mining operations.
The contracts to purchase coal for use at the jointly-owned facilities
require TEP to purchase minimum amounts of coal at an estimated average annual
cost of $19 million for the next five years.
NATURAL GAS
TEP typically uses generation from its facilities fueled by natural gas and
purchased power, in addition to energy from its coal-fired facilities, to meet
the summer peak demands of its retail customers and local reliability needs.
Some of these purchased power contracts are price indexed to natural gas prices.
Short-term and spot power purchase prices are also closely correlated to natural
gas prices. Due to its increasing seasonal gas and purchased power usage, TEP
hedges a portion of its total natural gas exposure from plant fuel, gas-indexed
purchased power and spot market purchases with fixed price contracts for a
maximum of three years. TEP purchases its remaining gas fuel needs and purchased
power in the spot and short-term markets.
K-8
TEP entered into a Gas Procurement Agreement with Southwest Gas Corporation
(SWG) effective June 1, 2001 with a primary term of five years. The contract
provides for a minimum annual volume obligation of 4 million MMBtu's for 2004
and 2005. In 2004, TEP purchased approximately 5.2 million MMBtu's and expects
to use more than the minimum in 2005. In the event fewer MMBtu's are purchased,
TEP is obligated to pay only the transportation component for any shortfall. TEP
made payments under this contract of $34 million in 2004, $34 million in 2003
and $33 million in 2002. In 2004, the average transportation cost per MMBtu was
$0.43 based on the volume of gas purchased by TEP, for a total of $2 million in
transportation costs.
In 2004, the average market price of natural gas at the Permian basin was
$5.44 per MMBtu, or 10% higher than 2003, due to low gas storage levels and gas
production concerns. 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 427,000
MWh, or 4% of total generation and purchased power in 2004 and 433,000 MWh, or
4% of total generation and purchased power in 2003. In 2004, TEP purchased a
total of 1,400,000 MWh of energy, or 11% of total generation and purchased
power, of which approximately 175,000 MWh were from gas-index priced energy
under long-term purchased power contracts with the remainder being from
short-term and spot power markets. See Rates and Regulation, State, Track B,
below for discussion of purchased power contracts.
WATER SUPPLY
Drought conditions in the Four Corners region, combined with water usage in
upper New Mexico, have resulted in decreasing water levels in the lake that
indirectly supplies water to the San Juan and Four Corners Generating Stations.
These conditions may affect the water supply of the plants in the future if
adequate moisture is not received in the watershed that supplies the area.
Although the moisture levels in the region during the 2004-2005 winter seasons
have been above historic averages, drought conditions persist. TEP has a 50%
ownership interest in each of San Juan units 1 and 2 (322 MW capacity) and a 7%
ownership interest in each of Four Corners units 4 and 5 (110 MW capacity).
PNM, the operating agent for San Juan, has negotiated supplemental water
contracts with the U.S. Bureau of Reclamation and the Jicarilla Apache Nation to
assist San Juan in meeting its water requirements in the event of a water
shortage.
Drought conditions in northern New Mexico and Colorado, combined with
increased water usage in Arizona, Nevada and southern California, have also
caused water levels to significantly recede at Lake Powell, which supplies
operating water for the Navajo Generating Station. If Lake Powell's water level
continues to recede, it will be necessary to lower the water intakes for Navajo.
TEP's share of the expected total cost is approximately $2 million based on its
7.5% ownership interest in Navajo Units 1, 2, and 3 (168 MW capacity).
SRP, the operating agent for Navajo, is monitoring the water levels at Lake
Powell. SRP will initiate the process of lowering Navajo's intakes if and when
it believes there is a reasonable chance that decreasing water levels will move
below the current intake level and interfere with plant operations.
TEP does not believe that its operations will be materially affected by
this drought. However, TEP cannot predict the ultimate length of the drought, or
whether it will adversely affect the amount of power available from the San
Juan, Four Corners and Navajo Generating Stations.
TRANSMISSION ACCESS
TEP has transmission access and power transaction arrangements with over
120 electric systems or suppliers. In May 2003, TEP completed construction of a
one mile 500-kV transmission line and related substations to enhance its
distribution system link to the regional high voltage transmission system north
of Tucson. This line improved system reliability and alleviated a bottleneck
that constrained power delivery to southern Arizona.
TUCSON TO NOGALES TRANSMISSION LINE
In January 2001, TEP and Citizens (now UES) entered into a project
development agreement for the joint construction of a 62-mile transmission line
from Tucson to Nogales, Arizona. This project was initiated by Citizens (now
K-9
UES) in response to an order by the ACC to improve reliability to its retail
customers in Nogales, Arizona. TEP is currently seeking approvals for the
project from the ACC, the Department of Energy (DOE), the U.S. Forest Service,
the U.S. Bureau of Land Management, and the International Boundary and Water
Commission.
The ACC approved the location and construction of the proposed 345-kV line
in January 2002. The DOE has completed a Final Environmental Impact Statement
(EIS) for the project in which it would accept any of the routes in the EIS but,
the U.S. Forest Service has indicated the Central route as its preferred
alternative, rather than the Western Corridor route, which was approved by the
ACC in 2002. As a result, the ACC has ordered TEP to re-open the state line
siting process. The ACC has also ordered TEP to investigate and engage in
discussions with ACC staff and intervenors regarding potential alternatives to
the line.
The DOE will use the EIS to help it decide whether to issue a Presidential
Permit that would allow TEP to extend the line across the border into Mexico.
The U.S. Forest Service will use the EIS to determine whether to grant a land
use permit for the project. Other federal agencies will also use the EIS for
their own permitting processes.
The future costs of construction to Nogales, Arizona are expected to be
approximately $76 million. Through December 31, 2004, approximately $10 million
in land acquisition, engineering and environmental expenses have been
capitalized related to this project. If TEP receives the required approvals in
2005 or early 2006, the forecasted capital expenditures for completing the
transmission line are: $3 million in 2005; $34 million in 2006; $37 million in
2007; and $2 million in 2008. If TEP does not receive the required approvals, it
may be required to expense $8 million of the costs that have been capitalized
related to the project, propose alternative methods to the ACC for approving
reliability and spend additional amounts to implement such alternatives. The
expenditures related to alternative methods for improving reliability are
expected to be less than $76 million.
REGIONAL AND FEDERAL TRANSMISSION ISSUES
In December 1999, the FERC issued FERC Order 2000, which established
timelines for all transmission owning entities to join a Regional Transmission
Organization (RTO) and defined the minimum characteristics and functions of an
RTO. TEP and three other southwestern utilities filed agreements and operating
protocols with the FERC in October 2001 to form a new, for-profit RTO to be
known as WestConnect RTO, LLC (WestConnect). In 2005, four other utilities
joined WestConnect.
WestConnect will be responsible for security, reservations, scheduling,
transmission expansion and planning, and congestion management for the regional
transmission system. It will also focus on ensuring reliability,
nondiscriminatory open-access, and independent governance. Regional transmission
owners would have the option, but not be required, to transfer ownership of
transmission assets to the RTO. At present, TEP intends to turn over only
operating control of its transmission assets to the RTO. Additionally, the RTO
may build new transmission lines in the region, which could be owned by the RTO.
In October 2002, the FERC issued a provisional order approving, in part,
the WestConnect RTO proposal. The FERC also required WestConnect, along with the
other two RTOs in the western region (the California Independent System Operator
(CISO) and RTO West), to participate in a steering group to encourage the
development of a seamless wholesale electric energy market. WestConnect's
operation is dependent on the resolution of these issues and is also subject to
approval by state regulatory agencies. WestConnect is following a phased
approach for development that will progress from development of a regional Open
Access Same Time Information System (OASIS) to full RTO implementation in three
or four phases. The first phase includes the regional OASIS (to be called
WesTTrans) that became operational in early 2004. The WesTTrans system includes
the WestConnect participants as well as some other entities throughout the west
that are outside of the WestConnect footprint. WestConnect is currently
developing future phasing plans.
On July 31, 2002, the FERC issued a Notice of Proposed Rulemaking (NOPR)
proposing standard market design rules that would significantly alter the
markets for wholesale electricity and transmission and ancillary services in the
U.S. The new rules would establish a generation adequacy requirement for
"load-serving entities" and a standard platform for the sale of electricity and
transmission services. Under the new rules, Independent Transmission Providers
would administer spot markets for wholesale power, ancillary services and
transmission congestion rights, and electric utilities, including TEP, would be
required to transfer control over transmission facilities to the applicable
Independent Transmission Provider. This effort by FERC provoked extensive
response from the industry as well as state regulators.
K-10
RATES AND REGULATION
The FERC and the ACC regulate portions of TEP's utility accounting
practices and electricity rates. The FERC regulates the terms and prices of
TEP's transmission services and sales of electricity at wholesale. In 1996, TEP
filed a tariff at FERC governing the rates, terms and conditions of open access
transmission services. In 1997, TEP was granted a FERC tariff to sell power at
market based rates. The ACC has authority over rates charged to retail
customers, the issuance of securities, and transactions with affiliated parties.
STATE
Historically, the ACC determined TEP's rates for retail sales of electric
energy on a "cost of service" basis, which was designed to provide, after
recovery of allowable operating expenses, an opportunity to earn a reasonable
rate of return on TEP's "fair value rate base." Fair value rate base was
generally determined by reference to the original cost and the reconstruction
cost (net of depreciation) of utility plant in service to the extent deemed used
and useful, and to various adjustments for deferred taxes and other items, plus
a working capital component. Over time, rate base was increased by additions to
utility plant in service and reduced by depreciation and retirements of utility
plant.
TEP'S SETTLEMENT AGREEMENT AND RETAIL ELECTRIC COMPETITION RULES
In September 1999, the ACC approved the Retail Electric Competition Rules
(Rules) that provided a framework for the introduction of retail electric
competition in Arizona. In November 1999, the ACC approved the Settlement
Agreement between TEP and certain customer groups related to the implementation
of retail electric competition in Arizona. See Item 7. - Management's Discussion
and Analysis of Financial Condition and Results of Operations, Tucson Electric
Power Company, Rates, for more information.
During 2002, the ACC reexamined circumstances that had changed since it
approved the Rules in 1999. The outstanding issues were divided into two groups.
Track A related primarily to the divestiture of generation assets while Track B
related primarily to the competitive energy bidding process.
TRACK A
In September 2002, the ACC issued the Track A Order, which eliminated the
requirement in the TEP Settlement Agreement that TEP transfer its generation
assets to a subsidiary. As a result, generation assets remain at TEP. At the
same time, the ACC ordered the parties, including TEP, to develop a competitive
bidding process, and reduced the amount of power to be acquired in the
competitive bidding process to only that portion not supplied by TEP's existing
resources.
TRACK B
In February 2003, the ACC issued the Track B Order, which defined the
competitive bidding process TEP must use to obtain capacity and energy
requirements beyond what is supplied by TEP's existing resources for the period
2003 through 2006. TEP estimated these amounts to be 50,000 MWh of energy in
2003, or approximately 0.5% of its retail load, gradually increasing to 104,000
MWh by 2006. The Track B Order further required TEP to bid out "Economy Energy",
or short-term energy purchases, that it estimates it will make in the 2003 to
2006 period (210,000 to 181,000 MWh).
TEP was also required to bid out its Reliability Must Run (RMR) generation
requirements, which are currently met by its existing local generation units.
TEP's RMR generation requirements were estimated at 471 MW of capacity and
37,000 MWh of energy in 2003 increasing to 687 MW of capacity and 38,000 MWh of
energy in 2005.
TEP was not required to purchase any power through this process that it
deems to be uneconomical, unreasonable or unreliable. The Track B bidding
process involved the ACC Staff and an independent monitor. The Track B Order
also confirmed that it is not intended to change the current retail rates for
generation services. TEP entered into two agreements to meets its 2003 bid
requirements under the Track B Order for the period 2003 through 2006.
The Track B Order set forth the requirements of the 2003 competitive
solicitation. The Track B Order did not address TEP's purchased power or asset
acquisitions occurring subsequent to the 2003 competitive solicitation.
K-11
See Generating and Other Resources, Other Purchases and Interconnections,
above.
ARIZONA COURT OF APPEALS DECISION INVALIDATING CERTAIN RETAIL ELECTRIC
COMPETITION RULES
In January 2005, an Arizona Court of Appeals decision became final in which
the Court held invalid certain portions of the ACC rules on retail competition
and related market pricing. Based on this decision, we expect that the ACC will
address the competition rules in an administrative proceeding during 2005. We
cannot predict what changes, if any, the ACC will make to the competition rules.
See Note 4 of the Notes to Consolidated Financial Statements - TEP
Regulatory Matters, for more information on TEP's Settlement Agreement.
TEP'S UTILITY OPERATING STATISTICS
For Years Ended December 31,
2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
Generation and Purchased Power - kWh (000)
Remote Generation (Coal) 10,159,729 10,182,706 10,067,069 10,362,211 10,278,393
Local Tucson Generation (Oil, Gas & Coal) 1,174,500 1,082,058 1,402,504 1,820,783 1,667,308
Purchased Power 1,322,084 1,153,305 1,329,574 3,656,978 3,174,244
- ------------------------------------------------------------------------------------------------------------------------------------
Total Generation and Purchased Power 12,656,313 12,418,069 12,799,147 15,839,972 15,119,945
Less Losses and Company Use 821,008 778,285 791,852 747,941 688,226
- ------------------------------------------------------------------------------------------------------------------------------------
Total Energy Sold 11,835,305 11,639,784 12,007,295 15,092,031 14,431,719
====================================================================================================================================
Sales - kWh (000)
Residential 3,459,750 3,389,744 3,181,030 3,159,504 3,041,446
Commercial 1,787,472 1,689,014 1,605,148 1,591,942 1,503,222
Industrial 2,226,314 2,245,340 2,254,174 2,297,476 2,272,285
Mining 829,028 701,638 692,448 1,053,152 1,145,891
Public Authorities 240,426 250,038 256,867 257,155 259,621
- ------------------------------------------------------------------------------------------------------------------------------------
Total - Electric Retail Sales 8,542,990 8,275,774 7,989,667 8,359,229 8,222,465
Electric Wholesale Sales 3,292,315 3,364,010 4,017,628 6,732,802 6,209,254
- ------------------------------------------------------------------------------------------------------------------------------------
Total Electric Sales 11,835,305 11,639,784 12,007,295 15,092,031 14,431,719
====================================================================================================================================
Operating Revenues (000)
Residential $ 315,402 $ 309,807 $ 291,390 $ 285,808 $ 279,067
Commercial 186,625 175,559 168,838 166,139 158,309
Industrial 161,338 160,276 161,749 162,523 162,888
Mining 38,549 28,022 28,072 41,940 48,460
Public Authorities 17,427 17,839 18,672 18,763 18,883
- ------------------------------------------------------------------------------------------------------------------------------------
Total - Electric Retail Sales 719,341 691,503 668,721 675,173 667,607
Electric Wholesale Sales 159,918 151,030 157,108 921,280 359,814
Other Revenues 10,039 9,018 8,618 8,508 3,908
- ------------------------------------------------------------------------------------------------------------------------------------
Total Operating Revenues $ 889,298 $ 851,551 $834,447 $1,604,961 $1,031,329
====================================================================================================================================
Customers (End of Period)
Residential 341,870 334,131 326,847 318,976 311,673
Commercial 32,923 32,369 31,767 31,194 30,467
Industrial 676 676 695 705 711
Mining 2 2 2 2 2
Public Authorities 61 61 61 61 61
- ------------------------------------------------------------------------------------------------------------------------------------
Total Retail Customers 375,532 367,239 359,372 350,938 342,914
====================================================================================================================================
Average Retail Revenue per kWh Sold (cents)
Residential 9.1 9.1 9.2 9.0 9.2
Commercial 10.4 10.4 10.5 10.4 10.5
Industrial and Mining 6.5 6.4 6.4 6.1 6.2
Average Retail Revenue per kWh Sold 8.4 8.4 8.4 8.1 8.1
Average Revenue per Residential Customer $ 933 $ 937 $ 902 $ 906 $ 906
Average kWh Sales per Residential Customer 10,231 10,249 9,842 10,015 9,878
K-12
ENVIRONMENTAL MATTERS
TEP is subject to environmental regulation of air and water quality,
resource extraction, waste disposal and land use by federal, state and local
authorities. TEP believes that all existing generating facilities are in
compliance with all existing regulations and will be in compliance with expected
environmental regulations, except as described below.
The 1990 Federal Clean Air Act Amendments (CAAA) require reductions of
sulfur dioxide (SO2) and nitrogen oxide (NOx) emissions in two phases. TEP is
subject to only Phase II of the SO2 and NOx emission reductions, which became
effective January 1, 2000. All of TEP's generating facilities (except 142 MW of
its internal combustion turbines) are affected.
EMISSION ALLOWANCES
In 1993, TEP's generating units affected by Phase II were allocated SO2
Emission Allowances based on past operational history. Each allowance gives the
owner the right to emit one ton of SO2. Beginning in 2000, generating units
subject to Phase II must hold Emission Allowances equal to the level of
emissions in the compliance year or pay penalties and offset excess emissions in
future years. TEP had sufficient Emission Allowances to comply with the Phase II
SO2 regulations for compliance years 2003 and 2004. TEP expects to continue to
have adequate Emission Allowances until Springerville Unit 3 goes into service.
At that point, due to reduced usage of Emission Allowances at Springerville Unit
1 and Unit 2, TEP expects to have excess Emission Allowances. Potential changes
to the allocation of SO2 allowances may impact these expectations in future
years.
Title V of the CAAA requires that all of TEP's generating facilities obtain
more complex air quality permits. All TEP facilities (including those jointly
owned and operated by others) have obtained these permits. In 1999, TEP received
Title V permits for the Springerville and Sundt generating stations. These
permits are valid for five years, and, as a result, TEP has submitted a permit
renewal application. TEP must pay an annual emission-based fee for each
generating facility subject to a Title V permit. These emission-based fees are
included in the CAAA compliance expenses discussed below. The CAAA also requires
multi-year studies of visibility impairment in specified areas and studies of
hazardous air pollutants. The results of these studies will impact the
development of future regulation of electric utility generating units. Since
these activities involve the gathering of information not currently available,
TEP cannot predict the outcome of these studies.
STATE REGULATION
Arizona and New Mexico have adopted regulations restricting the emissions
from existing and future coal, oil and gas-fired plants. These regulations are
in some instances more stringent than those adopted by the Environmental
Protection Agency (EPA). The principal generating units of TEP are located
relatively close to national parks, monuments, wilderness areas and Indian
reservations. Since these areas have relatively high air quality, TEP could be
subject to control standards that relate to the "prevention of significant
deterioration" of visibility and tall stack limitation rules. In addition, the
ACC mandated under the Environmental Portfolio Standard (EPS) that TEP derive a
percentage of its total retail energy sold from new solar resources or
environmentally-friendly renewable electricity technologies. The percentage
changes each year, increasing to a maximum of 1.1 percent in 2007. In 2004, the
percentage was 0.8 percent of which at least 60 percent must be derived from
solar electric generation. See Note 8. Commitments and Contingencies, TEP
Contingencies, Litigation and Claims Related to San Juan Generating Station.
MERCURY EMISSIONS
The EPA has issued a determination that coal and oil-fired electric utility
steam generating units must control their mercury emissions. On March 15, 2005,
the EPA adopted regulations relating to mercury emissions under Section 111 of
the Clean Air Act. Additional rule-making procedures will take place at the
state level prior to implementation of the new regulations. TEP is analyzing the
potential impact of the regulations on its operations. Until these state
procedures are adopted, TEP cannot determine if it will be significantly
affected. If TEP is not allocated sufficient allowances for its current
emissions, it may have to purchase additional allowances on the market, or
implement additional controls to reduce emissions.
CAPITAL AND OPERATING COSTS
TEP capitalized $9 million in 2004, $11 million in 2003 and $8 million in
2002 in construction costs to comply with environmental requirements and expects
to capitalize $1 million in 2005 and $1 million in 2006. In addition, TEP
recorded expenses of $9 million in 2004, $8 million in 2003 and $6 million in
2002 and 2001 related to environmental compliance, including the cost of lime
used to scrub the stacks. TEP expects environmental expenses to be $8 million in
K-13
2005. TEP may incur additional costs to comply with recent and future changes in
federal and state environmental laws, regulations and permit requirements at
existing electric generating facilities. Compliance with these changes may
result in a reduction in operating efficiency.
In order to meet Title V permit requirements in connection with the
construction of Springerville Unit 3, the Unit 3 project will pay for
approximately $90 million of capital expenditures related to pollution control
equipment upgrades on Springerville Unit 1 and Unit 2. See Note 8. Commitments
and Contingencies, TEP Contingencies, Springerville Generating Station
Complaint.
UNS GAS
- -------
On August 11, 2003, UniSource Energy completed the purchase of the Arizona
gas and electric system assets from Citizens for a total of $223 million,
comprised of the base purchase price plus other operating capital adjustments
and transaction costs. UES was formed to hold the common stock of UNS Gas and
UNS Electric, which operate these gas and electric system assets, respectively.
SERVICE TERRITORY AND CUSTOMERS
UNS Gas is a gas distribution company serving approximately 133,000 retail
customers in Mohave, Yavapai, Coconino, and Navajo Counties in northern Arizona,
as well as Santa Cruz County in southeast Arizona. These counties comprise
approximately 50% of the territory of the state of Arizona, with a population of
approximately 727,000 in 2004.
UNS Gas' customer base is primarily residential. Total revenues derived
from residential customers were approximately 60% in 2004, while sales to other
retail customer classes accounted for approximately 28% of total revenues.
Approximately 12% of total revenues in 2004 were derived from gas transportation
services and a Negotiated Sales Program (NSP). UNS Gas is supplying natural gas
transportation service to the 600 MW Griffith Power Plant located near Kingman,
Arizona, under a 20-year contract which expires in 2021. UNS Gas also supplies
natural gas to some of its large transportation customers, through an NSP
approved by the ACC. One half of the margin earned on these NSP sales is
retained by UNS Gas, while the other half benefits retail customers through a
credit to the purchased gas adjustor (PGA) mechanism which reduces the gas
commodity price.
GAS SUPPLY AND TRANSMISSION
UNS Gas has a natural gas supply and management agreement with BP Energy
Company (BP). Under the contract, BP manages UNS Gas' existing supply and
transportation contracts and its incremental requirements. The initial term of
the agreement extends through August 31, 2005. The term of the agreement is
automatically extended for one year on an annual basis unless either party
provides 180 days notice of its intent to terminate. The market price for gas
supplied by BP will vary based upon the period during which the commodity is
delivered. UNS Gas hedges its gas supply prices by entering into a fixed price
forward contracts at various times during the year to provide more stable prices
to its customers. These purchases are made up to three years in advance with the
goal of hedging at least 45% and not more than 80% of the expected monthly gas
consumption with fixed prices prior to entering into the month. UNS Gas hedged
approximately 60% of its expected monthly consumption for the 2004/2005 winter
season (November through March). Additionally, UNS Gas has approximately 50% of
its expected gas consumption hedged for April through July of 2005, and 35%
hedged for the period of August 2005 through July of 2006.
Most of the gas distributed by UNS Gas in Arizona is procured from the San
Juan Basin in the Four Corners region and delivered on the El Paso and
Transwestern interstate pipeline systems. UNS Gas has firm transportation
agreements with El Paso Natural Gas (EPNG) and Transwestern Pipeline Company
(Transwestern) with combined capacity sufficient to meets its load requirements.
In July 2003, FERC required the conversion of UNS Gas' full requirements
status under the EPNG agreement to contract demand starting on September 1,
2003. UNS Gas now has specific volume limits in each month and specific receipt
point rights from the available supply basins (San Juan and Permian). The
average daily capacity rights of UNS Gas after conversion to contract demand is
approximately 870,000 therms per day, with an average of 1,200,000 therms per
day in the winter season (November through March). These changes have also
reduced the amount of less expensive San Juan gas available to UNS Gas. The
impact, however, is not expected to be material. The annual cost of the EPNG
capacity after conversion to contract demand did not change. These costs will be
the same through 2005 (pending a 2006 EPNG rate case after which the rates are
K-14
expected to increase) as under UNS Gas' existing full requirements contract.
This contract expires in August 2011.
UNS Gas has capacity rights of 250,000 therms per day on the San Juan
Lateral and Mainline of the Transwestern pipeline. The Transwestern pipeline
principally delivers gas to the portion of UNS Gas' distribution system serving
customers in Flagstaff and Kingman, Arizona, and also delivers gas to UNS Gas'
facilities serving the Griffith Power Plant in Mohave County. This contract
expires in January 2007.
The aggregate annual minimum transportation charges are expected to be
approximately $4 million and $3 million for the EPNG and Transwestern contracts,
respectively. These costs are passed through to our customers via the PGA
mechanism. See Rates and Regulation, below.
RATES AND REGULATION
UNS Gas is regulated by the ACC with respect to retail gas rates, the
issuance of securities, and transactions with affiliated parties. UNS Gas'
retail gas rates include a monthly customer charge, a base rate charge for
delivery services and the cost of gas (expressed in cents per therm), and a PGA
mechanism.
Purchased Gas Adjustor
----------------------
UNS Gas' retail rates include a PGA mechanism intended to address the
volatility of natural gas prices and allow UNS Gas to recover its costs through
a price adjuster. The difference between the actual cost of UNS Gas' gas
supplies and transportation contracts and the base cost of gas approved by the
ACC for recovery through base rates are deferred and recovered or repaid through
the PGA mechanism. The PGA charge changes monthly based on an ACC approved
mechanism that compares the twelve-month rolling average gas costs to the base
cost of gas, subject to limitations on how much the price per therm may change
in a twelve month period. When under or over recovery trigger points are meet,
UNS Gas may request a PGA surcharge or surcredit to collect or return the amount
deferred from or to customers.
ACC Order and Settlement Agreement
----------------------------------
The ACC order and settlement agreement approving the acquisition of the
Citizens gas and electric assets included the following terms related to UNS Gas
rates:
o An increase in retail delivery base rates, effective August 11, 2003,
equivalent to a 20.9% increase over 2001 test year retail revenues.
o Fair value rate base of $142 million and allowed rate of return of
7.49%, based on a cost of capital of 9.05%, derived from a cost of
equity of 11.00% and a cost of debt of 7.75% (based on a capital
structure of 40% equity and 60% debt).
o Change in rate design to include an increase in the monthly
residential customer charge from $5 to $7 and an increase in the base
cost of gas to $0.400 per therm from $0.250 in northern Arizona and
$0.3884 in Santa Cruz County.
o The then existing PGA rate change limit of $0.10 per therm over a
twelve-month period was increased to $0.15 through July 2004 and
thereafter reverted to $0.10.
On September 9, 2003, the ACC approved a new PGA surcharge of $0.1155 per
therm that took effect October 1, 2003 and ended November 1, 2004.
In January 2005, UNS Gas requested that the ACC approve a PGA surcharge of
$0.06 per therm beginning April 1, 2005 and remove it one year later, to recover
its excess gas purchase costs. On March 3, 2005, the ACC staff in its proposed
order, recommended the implementation of a $0.05 per therm surcharge beginning
April 1, 2005 to recover the uncollected PGA balance. At December 31, 2004, the
unrecovered PGA balance was $9 million.
Under the terms of the ACC order, UNS Gas may not file for a general rate
increase until August 2006 and any resulting rate increase may not become
effective until August 1, 2007. UNS Gas expects to file a general rate case in
August 2006. The settlement agreement also limits dividends payable by UNS Gas
to 75% of earnings until the ratio of common equity to total capitalization
reaches 40%. The ratio of common equity to total capitalization for UNS Gas at
December 31, 2004 was 37%.
K-15
On March 10, 2005, UniSource Energy made a $6 million equity investment in
UNS Gas which increased its ratio of common equity to total capitalization to
40%.
UNS ELECTRIC
- ------------
SERVICE TERRITORY AND CUSTOMERS
UNS Electric is an electric transmission and distribution company serving
approximately 85,000 retail customers in Mohave and Santa Cruz counties. These
counties had a population of approximately 222,000 in 2004.
UNS Electric's customer base is primarily residential, with some small
commercial and both light and heavy industrial customers. Peak demand for 2004
was 383 MW.
POWER SUPPLY AND TRANSMISSION
UNS Electric has a full requirements power supply agreement with Pinnacle
West Capital Corporation (PWCC). The agreement expires May 31, 2008. The
agreement obligates PWCC to supply all of UNS Electric's power requirements at a
fixed price. Payments under the contract are usage based, with no fixed customer
or demand charges. UNS Electric imports the power it purchases from PWCC into
its Mohave County and Santa Cruz County services territories over the Western
Area Power Administration's (WAPA) transmission lines. UNS Electric's
transmission capacity agreement with WAPA expires in February 2008. Under the
terms of the agreement, UNS Electric's aggregate minimum fixed transmission
charges are expected to be $5 million in 2005. UNS Electric also has a long-term
electric transmission capacity agreement with WAPA that expires in 2011. Under
the terms of this contract, the aggregate minimum transmission payments are $1
million per year.
UNS Electric owns and operates the Valencia Power Plant (Valencia), located
in Nogales, Arizona. The Valencia plant consists of three gas and diesel-fueled
combustion turbine units and provides approximately 48 MW of peaking resources.
The facility is directly interconnected with the distribution system serving the
city of Nogales and the surrounding areas. Under the PWCC agreement, Valencia
will be dispatched by PWCC when needed for local reliability or when it is
economic relative to other PWCC resources.
RATES AND REGULATION
UNS Electric is regulated by the ACC with respect to retail electric rates,
the issuance of securities, and transactions with affiliated parties, and by the
FERC with respect to wholesale power contracts and interstate transmission
service. UNS Electric's retail electric rates include a purchase power and fuel
adjustment clause (PPFAC), which allows for adjustment to the base rate for
delivered purchase power through a separate surcharge or credit.
The ACC order and settlement agreement approving the acquisition of the
Citizens gas and electric assets include the following terms related to UNS
Electric rates:
o A 22% increase in retail rates effective August 11, 2003 from the
rates previously in effect for Citizens. This reflects the
implementation of a PPFAC surcharge of $0.01825 per kWh, which
combined with the current base rate of $0.05194 per kWh, results in a
new delivered purchase power price of $0.07019 per kWh, to fully
recover the cost of the current contract with PWCC, WAPA transmission
charges and the cost of running the Valencia turbines.
o UNS Electric must attempt to renegotiate the PWCC purchase power
contract, and any savings that result from a renegotiated contract
must be allocated in a ratio of 90% to ratepayers and 10% to
shareholders. Discussions are underway relating to restructuring
options, however to date, no agreement had been reached.
Under the terms of the ACC order, UNS Electric may not file a general rate
increase until August 2006 and any resulting rate increase may not become
effective until August 1, 2007. UNS Electric expects to file a general rate case
in August 2006. The settlement agreement also limits dividends payable by UNS
Electric to 75% of earnings until the ratio of common equity to total
capitalization reaches 40%. The ratio of common equity to total capitalization
for UNS Electric at December 31, 2004 was 40%.
On March 10, 2005, UniSource Energy made a $4 million equity investment in
UNS Electric.
K-16
GLOBAL SOLAR ENERGY, INC.
- -------------------------
Global Solar Energy, Inc. (Global Solar) develops and manufactures light
weight thin-film photovoltaic cells and panels. Global Solar's target markets
have included military, space and commercial applications. Millennium owns 99%
of Global Solar, and at December 31, 2004, Global Solar represented 1% of
UniSource Energy's total assets. To date, Millennium has been authorized to fund
up to an additional $5 million for capital expenditures and operations at Global
Solar.
OTHER
- -----
OTHER MILLENNIUM INVESTMENTS
Through affiliates, Millennium holds investments in unregulated energy and
emerging technology companies. At December 31, 2004, Millennium's assets,
excluding Global Solar, represented 6% of UniSource Energy's total assets. It is
our intention for UniSource Energy to cease making capital contributions to
Millennium. See Item 7. - Management's Discussion and Analysis of Financial
Condition and Results of Operations, Millennium Energy Holdings, Inc., Results
of Operations, Millennium Commitments.
Millennium's other consolidated investments include:
Infinite Power Solutions, Inc. (IPS) develops thin-film lithium ion
batteries. Millennium owns 72% of IPS. To date, Millennium has been authorized
to fund up to $3 million for capital and operations at IPS.
Southwest Energy Solutions, Inc. (SES), a wholly-owned Millennium
subsidiary, provides electrical contracting services in Arizona to commercial,
industrial and governmental customers in both high voltage and inside wiring
capacities and meter reading services to TEP.
Millennium Environmental Group, Inc. (MEG), a wholly-owned Millennium
subsidiary established in September 2001, manages and trades emission
allowances, coal and other environmental related products including derivative
instruments. In accordance with UniSource Energy's intention to cease making
capital contributions to Millennium, Millennium has significantly reduced the
holdings and activity of MEG. MEG is in the process of winding down its
activities and does not anticipate engaging in any new activities after 2005.
Nations Energy Corporation (Nations Energy), a wholly-owned subsidiary of
Millennium, develops and invests in independent power projects worldwide.
Nations Energy has one remaining investment, a 32% equity interest in an
independent power producer that owns and operates a 43 MW power plant near
Panama City, Panama.
EQUITY METHOD MILLENNIUM INVESTMENTS
Millennium has the following equity method investments:
MicroSat Systems, Inc. (MicroSat) develops small-scale satellites under
U.S. government contracts. Millennium owns 35% of MicroSat.
Haddington Energy Partners II, LP (Haddington) is a limited partnership
that funds energy-related investments. A member of the UniSource Energy Board of
Directors has an investment in Haddington and is a managing director of the
general partner of the limited partnership. Millennium committed $15 million in
capital, excluding fees, to Haddington in exchange for approximately 31%
ownership. At December 31, 2004, Millennium had $4 million remaining on this
commitment, which is expected to be funded over the next two years.
Valley Ventures III, LP (Valley Ventures) is a venture capital fund that
focuses on investments in information technology, microelectronics and
biotechnology, primarily within the southwestern U.S. Another member of the
UniSource Energy Board of Directors is a general partner of the company that
manages the fund. Millenium committed $6 million, including fees, to the fund
and owns approximately 15% of the fund. At December 31, 2004, Millennium had $3
million remaining on this commitment, which is expected to be funded over the
next four years.
Carboelectrica Sabinas, S. de R.L. de C.V. (Sabinas) is a Mexican limited
liability company created to develop up to 800 MW of coal-fired generation in
the Sabinas region of Coahuila, Mexico. Sabinas also owns 19.5% of Minerales de
Monclova, S.A. de C.V. (Mimosa). Mimosa is an owner of coal and associated gas
K-17
reserves and a supplier of metallurgical coal to the Mexican steel industry and
thermal coal to the major electric utility in Mexico. Millennium owns 50% of
Sabinas. Altos Hornos de Mexico, S.A. de C.V. (AHMSA) and affiliates also own
50%. Also, UniSource Energy's Chairman, President and Chief Executive Officer is
a member of the Board of Directors of 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 reach financial closing on the
generation project within a specified time. Millennium's put option is secured
by collateral currently valued in excess of $20 million. In 2003, Millennium
received $1 million of returned capital from the investment. At December 31,
2004, the book value of the investment in Sabinas was approximately $19 million.
As technology developers, IPS and MicroSat face many challenges, such as
developing technologies that can be manufactured on an economic scale,
technological obsolescence, competitors and possible reductions in government
spending to advance technological research and development activities. See Item
7. - Management's Discussion and Analysis of Financial Condition and Results of
Operations, Other, Results of Operations for more information regarding
Millennium's unregulated energy businesses and other investments, including
research and development activities.
UNISOURCE ENERGY DEVELOPMENT COMPANY
In October 2003, UED, TEP, Tri-State and SRP entered into a joint
development agreement, which provides for the development of two 400 MW
coal-fired units at TEP's existing Springerville Generating Station by parties
other than TEP. Based on this Agreement, TEP transferred the right to construct
Unit 3, together with associated rights, to Tri-State.
Springerville was originally designed for four units. Springerville Unit 3,
and, if constructed, Unit 4, will each consist of a 400 MW coal-fired, base-load
generating facility at the same site as Springerville Units 1 and 2. When Unit 3
(and possibly Unit 4) is built, TEP would spread the fixed costs of the existing
common facilities over the additional generating unit (or units).
In October 2003, Tri-State completed financing of Unit 3 and immediately
began construction. UED received reimbursement of its development costs totaling
$29 million, and an $11 million development fee.
Once built, Tri-State will lease 100% of Unit 3 from a financial owner and
take 300 MW of the 400 MW capacity. TEP will operate Unit 3 and will purchase up
to 100 MW of Tri-State system capacity for no more than five years from the time
the plant begins commercial operation. UED expects commercial operation of Unit
3 to occur in the third quarter of 2006. SRP will purchase 100 MW of capacity
from Unit 3 under a 30 year power purchase agreement and will have the right to
construct and own Unit 4 at a later date. If SRP decides to construct Unit 4,
TEP may be required, along with Tri-State, to exercise best efforts to find a
replacement purchaser for SRP to purchase 100 MW of capacity from Unit 3. If TEP
and Tri-State are unable to find such a replacement purchaser, TEP would then
purchase 100 MW of output from Unit 4, beginning with the commercial operation
of Unit 4. Under the terms of the existing EPA permit, Unit 4 is required to be
completed by December 31, 2009.
Upon the completion of construction, TEP expects to receive annual pre-tax
benefits of approximately $15 million in the form of cost savings, rental
payments, transmission revenues, and other fees. TEP will also benefit from
upgraded emissions controls for Units 1 and 2, totaling approximately $90
million, which will be paid for by the Unit 3 project.
EMPLOYEES (AS OF DECEMBER 31, 2004)
- -----------------------------------
TEP had 1,208 employees, of which approximately 56% are represented by the
International Brotherhood of Electrical Workers (IBEW) Local No. 1116. A
three-year collective bargaining agreement between the IBEW and TEP was ratified
in December 2002 and extends through 2005. Wages for bargaining unit employees
increased 3% effective January 3, 2005. Wage increases for 2005 and 2006 will be
determined annually during July and August of each preceding year.
UNS Gas had 195 employees, of which 108 employees were represented by IBEW
Local No. 1116 and 6 employees were represented by IBEW Local No. 387. The
agreements with the IBEW Local 1116 and No. 387 expire in June 2009 and February
2010, respectively.
K-18
UNS Electric had 155 employees, of which 30 employees were represented by
the IBEW Local No. 387 and 99 employees were represented by the IBEW Local No.
769. The existing agreement with the IBEW Local No. 387 expires in February 2010
and the agreement with IBEW Local No. 769 expires in July 2007.
Global Solar had 82 employees.
Millennium and its other wholly-owned subsidiaries, which include SES and
MEG, had 190 employees. SES had 184 employees, of which approximately 95% are
represented by unions. Of the employees represented by unions, 76% are
represented by IBEW Local No. 1116, 15% by IBEW Local 769, 8% by IBEW Local No.
570 and 1% by IBEW Local No. 387. The existing agreements expire as follows:
IBEW Local No. 1116, October 2006; IBEW Local No. 769, July 2007; IBEW Local No.
570, May 2006; and IBEW Local No. 387, February 2010.
SEC REPORTS AVAILABLE ON UNISOURCE ENERGY'S WEBSITE
- ---------------------------------------------------
UniSource Energy and TEP make available their annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments
to those reports as soon as reasonably practicable after they electronically
file them with, or furnish them to, the SEC. These reports are available free of
charge through UniSource Energy's website address:
http://www.unisourceenergy.com. A link from UniSource Energy's website to these
SEC reports is accessible as follows: At the UniSource Energy main page, select
Investor Relations from the menu shown at the top of the page; next select SEC
filings from the menu shown on the Investor Relations page.
Information contained at UniSource Energy's website is not part of any
report filed with the SEC by UniSource Energy or TEP.
The SEC also maintains an Internet site that contains reports, proxy and
information statements, and other information regarding issuers that file
electronically with the SEC. The SEC website address is http://www.sec.gov.
Interested parties may also read and copy any materials UniSource Energy or 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.
ITEM 2. - PROPERTIES
- --------------------------------------------------------------------------------
TEP PROPERTIES
- --------------
TEP's transmission facilities, located in Arizona and New Mexico, transmit
electricity from TEP's remote electric generating stations at Four Corners,
Navajo, San Juan and Springerville to the Tucson area for use by TEP's retail
customers (see Item 1. - Business - Generating and Other Resources). The
transmission system is interconnected at various points in Arizona and New
Mexico with a number of regional utilities. TEP has arrangements with
approximately 120 companies to interchange generation capacity and transmission
of energy.
As of December 31, 2004, TEP owned, or participated in, an overhead
electric transmission and distribution system consisting of:
o 512 circuit-miles of 500-kV lines;
o 1,122 circuit-miles of 345-kV lines;
o 371 circuit-miles of 138-kV lines;
o 434 circuit-miles of 46-kV lines; and
o 3,362 circuit-miles of lower voltage primary lines.
The underground electric distribution system is comprised of 4,150
cable-miles. TEP owns approximately 77% of the poles on which the lower voltage
lines are located. Electric substation capacity consisted of 198 substations
with a total installed transformer capacity of 6,018,772 kilovolt amperes.
The electric generating stations (except as noted below), operating
headquarters, warehouse and service center are located on land owned by TEP. The
electric distribution and transmission facilities owned by TEP are located:
o on property owned by TEP;
K-19
o under or over streets, alleys, highways and other public places, the
public domain and national forests and state lands under franchises,
easements or other rights which are generally subject to termination;
o under or over private property as a result of easements obtained
primarily from the record holder of title; or
o over American Indian reservations under grant of easement by the
Secretary of Interior or lease by American Indian tribes.
It is possible that some of the easements, and the property over which the
easements were granted, may have title defects or may be subject to mortgages or
liens existing at the time the easements were acquired.
Springerville is located on land parcels held by TEP under a long-term
surface ownership agreement with the State of Arizona.
Four Corners and Navajo are located on properties held under easements from
the United States and under leases from the Navajo Nation. TEP, individually and
in conjunction with PNM in connection with San Juan, has acquired easements and
leases for transmission lines and a water diversion facility located on land
owned by the Navajo Nation. TEP has also acquired easements for transmission
facilities, related to San Juan, Four Corners, and Navajo, across the Zuni,
Navajo and Tohono O'odham Indian Reservations.
TEP's rights under these various easements and leases may be subject to
defects such as:
o possible conflicting grants or encumbrances due to the absence of or
inadequacies in the recording laws or record systems of the Bureau of
Indian Affairs and the American Indian tribes;
o possible inability of TEP to legally enforce its rights against
adverse claimants and the American Indian tribes without Congressional
consent; or
o failure or inability of the American Indian tribes to protect TEP's
interests in the easements and leases from disruption by the U.S.
Congress, Secretary of the Interior, or other adverse claimants.
These possible defects have not interfered and are not expected to
materially interfere with TEP's interest in and operation of its facilities.
TEP, under separate sale and leaseback arrangements, leases the following
generation facilities (which do not include land):
o coal handling facilities at Springerville;
o a 50% undivided interest in the Springerville Common Facilities;
o Springerville Unit 1 and the remaining 50% undivided interest in the
Springerville Common Facilities; and
o Sundt Unit 4 and related common facilities.
See Note 10 of Notes to Consolidated Financial Statements, and Item 7. -
Management's Discussion and Analysis of Financial Condition and Results of
Operations, Tucson Electric Power Company, Liquidity and Capital Resources,
Contractual Obligations, for additional information on TEP's capital lease
obligations.
Substantially all of the utility assets owned by TEP are subject to the
lien of the General First Mortgage and the General Second Mortgage.
Springerville Unit 2, which is owned by San Carlos, is not subject to those
liens.
UES PROPERTIES
- --------------
UNS GAS
As of December 31, 2004, UNS Gas' transmission and distribution system
consisted of approximately 78 miles of steel transmission mains, 3,399 miles of
steel and plastic distribution mains, and 137,874 customer service lines.
UNS ELECTRIC
As of December 31, 2004, UNS Electric's transmission and distribution
system consisted of approximately 56 circuit-miles of 115-kV transmission lines,
K-20
224 circuit-miles of 69-kV transmission lines, and 3,189 circuit-miles of
underground and overhead distribution lines. UNS Electric also owns 38
substations having a total installed capacity of 1,131,300 kilovolt amperes and
the 48 MW Valencia plant.
The gas and electric distribution and transmission facilities owned by UNS
Gas and UNS Electric are located:
o on property owned by UNS Gas or UNS Electric;
o under or over streets, alleys, highways and other public places, the
public domain and national forests and state lands under franchises,
easements or other rights which are generally subject to termination;
or
o under or over private property as a result of easements obtained
primarily from the record holder of title.
It is possible that some of the easements, and the property over which the
easements were granted, may have title defects or may be subject to mortgages or
liens existing at the time the easements were acquired.
GLOBAL SOLAR PROPERTIES
- -----------------------
Global Solar leases its manufacturing facilities from Millennium. The
manufacturing facility is located in Tucson, Arizona and is approximately 31,000
square feet.
ITEM 3 - LEGAL PROCEEDINGS
- --------------------------------------------------------------------------------
See Item 7. - Management's Discussion and Analysis of Financial Condition
and Results of Operations, Tucson Electric Power Company, Factors Affecting
Operations, for litigation related to ACC orders and retail competition.
We discuss other legal proceedings in Note 8 of Notes to Consolidated
Financial Statements.
CROSS-COMPLAINTS IN WHOLESALE ELECTRICITY ANTITRUST CASES I AND II
In late 2000, various California municipalities and citizens filed suits
against Duke Energy Trading and Marketing, L.L.C., Reliant Energy Services, Inc.
and other large suppliers of wholesale electricity alleging that Duke, Reliant,
and the other large suppliers violated antitrust laws by colluding to effect the
price of electricity in the California wholesale electricity market. These
actions were subsequently consolidated in San Diego Superior Court in March 2002
as Wholesale Electricity Antitrust Cases I and II.
Duke and Reliant responded by filing cross-complaints against TEP and
numerous other wholesale electricity market participants in April 2002. The
cross complaints allege that cross-defendants sold power in significant amounts
at prices the antitrust plaintiffs allege were excessive, and as participants in
power sales, cross-defendants are equally liable for plaintiffs alleged damages.
The entire action was removed to the United States District Court for the
Southern District of California in May 2002. The antitrust plaintiffs responded
to the removal by filing a motion for remand, and on December 13, 2002, the
District Court remanded the case back to state court.
Duke and Reliant appealed the District Court's remand order and requested
that the order be stayed pending resolution of their appeal. On December 8,
2004, the Ninth Circuit affirmed the District Court's remand. Once the mandate
issues and the case is actually transferred, TEP and other defendants will then
file a motion to dismiss the cross-complaint.
TEP believes these claims are without merit and intends to vigorously
contest them.
CITY OF TACOMA
On June 7, 2004, the City of Tacoma, Washington filed a lawsuit (City of
Tacoma v. American Electric Power Services Corporation, et al. (U.S. District
Ct. W. D. Wash.)) against TEP and various other electricity generators and
marketers alleging that the defendants violated antitrust laws by colluding to
effect the price of electricity in the Pacific Northwest from May 2000 through
2001. These claims are similar to those alleged in the antitrust cases against
TEP and other wholesale electricity market participants described above in
Cross-Complaints in Wholesale Electricity Antitrust Cases I and II. Accordingly,
on September 14, 2004, the case was transferred to the United States District
K-21
Court for the Southern District of California and consolidated with the
Wholesale Electricity Antitrust Cases I and II. TEP along with other defendants
have filed a motion to dismiss the City of Tacoma complaint.
TEP believes these claims are without merit and intends to vigorously
contest them.
CALIFORNIA ATTORNEY GENERAL'S UNFAIR COMPETITION LAWSUITS
Beginning in April 2002, the California Attorney General filed complaints
against TEP and other wholesale electricity suppliers or marketers in San
Francisco Superior Court. The complaints seek to impose civil penalties under
California's unfair competition law based upon allegations that defendants
violated the Federal Power Act by failing to properly file their rates with FERC
and by charging "unjust and unreasonable" rates.
Defendants removed the cases to the United States District Court for the
Northern District of California where they were consolidated. The District Court
then dismissed the California Attorney General's complaints finding them barred
by federal preemption and the filed rate doctrine. The California Attorney
General appealed the District Court's dismissal of the complaints. On October
12, 2004, the Ninth Circuit Court of Appeals issued a memorandum decision
affirming the dismissal and that decision is now final.
ITEM 4. - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- --------------------------------------------------------------------------------
Not applicable.
PART II
ITEM 5. - MARKET FOR REGISTRANT'S COMMON EQUITY RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF COMMON EQUITY
- --------------------------------------------------------------------------------
STOCK TRADING
UniSource Energy's Common Stock is traded under the ticker symbol UNS. It
is listed on the New York Stock Exchange and the Pacific Exchange. On March 11,
2005, the closing price was $30.54, with 13,196 shareholders of record.
UniSource Energy did not purchase any shares of its common stock during the
fourth quarter of 2004.
DIVIDENDS
UniSource Energy's Board of Directors currently expects to continue to pay
regular quarterly cash dividends on our common stock subject, however, to the
directors' evaluation of our financial condition, earnings, cash flows and
dividend policy. On February 4, 2005, UniSource Energy's Board of Directors
indicated its desire to target, over the next several years, a dividend payout
level of up to 50 percent of net income.
TEP pays dividends on its common stock after its Board of Directors
declares them. UniSource Energy is the primary shareholder of TEP's common
stock. UniSource Energy relies on dividends from its subsidiaries, primarily
TEP, to declare and pay dividends to its shareholders. See Note 12 of Notes to
Consolidated Financial Statements for a discussion of limitations on UniSource
Energy's subsidiaries ability to pay dividends to UniSource Energy.
See Item 7. - Management's Discussion and Analysis of Financial Condition
and Results of Operations, UniSource Energy Consolidated, Dividends on Common
Stock.
COMMON STOCK DIVIDENDS AND PRICE RANGES
---------------------------------------------------------------------------
2004 2003
Quarter: Market Price per Dividends Market Price per Dividends
Share of Common Declared Share of Common Declared
Stock (1) Stock (1)
High Low High Low
---- --- ---- ---
K-22
First $24.74 $ 24.11 $0.16 $18.10 $ 16.00 $0.15
Second 24.93 24.15 0.16 19.27 17.05 0.15
Third 24.94 24.20 0.16 19.80 17.65 0.15
Fourth 24.88 22.90 0.16 24.90 19.01 0.15
---------------------------------------------------------------------------
Total $0.64 $0.60
===========================================================================
(1) UniSource Energy's Common Stock price as reported in the consolidated
reporting system.
On February 4, 2005, UniSource Energy declared a cash dividend of $0.19 per
share on its Common Stock. The dividend was paid March 8, 2005 to shareholders
of record at the close of business February 15, 2005.
TEP declared and paid cash dividends of $32 million in 2004, $80 million in
2003, and $35 million in 2002.
CONVERTIBLE SENIOR NOTES
On March 1, 2005, UniSource Energy issued $150 million aggregate principal
amount of 4.50% Convertible Senior Notes due 2035 through a domestic offering to
qualified institutional buyers pursuant to Rule 144A under the Securities Act of
1933 (the Act) and to non-U.S. persons in offshore transactions in reliance on
Regulation S under the Act. See Item 7. - Management's Discussion and Analysis
of Financial Condition and Results of Operations, UniSource Energy Consolidated,
Liquidity and Capital Resources, Financing Activities.
ITEM 6. - SELECTED CONSOLIDATED FINANCIAL DATA
- --------------------------------------------------------------------------------
UNISOURCE ENERGY 2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------
- In Thousands -
(except per share data)
SUMMARY OF OPERATIONS
- ------------------------------------------------------------------------------------------------------------------------------
Operating Revenues (1) $1,168,978 $ 972,755 $ 839,576 $ 1,613,304 $ 1,036,630
Loss Before Income Taxes of Millennium $ (6,920) $ (26,350) $ (30,702) $ (14,455) $ (12,059)
Energy Businesses
Income Before Extraordinary Item and $ 45,919 $ 46,470 $ 34,928 $ 63,369 $ 43,484
Accounting Change (1)
Net Income (1) (2) $ 45,919 $ 113,941 $ 34,928 $ 63,839 $ 43,484
Basic Earnings per Share:
Before Extraordinary Item & Accounting
Change $ 1.34 $ 1.38 $ 1.04 $ 1.90 $ 1.34
Net Income $ 1.34 $ 3.37 $ 1.04 $ 1.91 $ 1.34
Diluted Earnings per Share:
Before Extraordinary Item & Accounting
Change $ 1.31 $ 1.35 $ 1.02 $ 1.86 $ 1.32
Net Income $ 1.31 $ 3.32 $ 1.02 $ 1.87 $ 1.32
Shares of Common Stock Outstanding
Average 34,380 33,828 33,665 33,398 32,445
End of Year 34,255 33,788 33,579 33,502 33,219
Year-end Book Value per Share $16.95 $16.47 $13.60 $13.17 $11.60
Cash Dividends Declared per Share $ 0.64 $ 0.60 $ 0.50 $ 0.40 $ 0.24
- ------------------------------------------------------------------------------------------------------------------------------
FINANCIAL POSITION
- ------------------------------------------------------------------------------------------------------------------------------
Total Utility Plant - Net $2,081,137 $ 2,069,215 $ 1,835,904 $ 1,832,164 $ 1,848,975
Investments in Lease Debt and Equity $ 170,893 $ 178,789 $ 191,867 $ 84,459 $ 71,639
Other Investments and Other Property $ 85,035 $ 109,570 $ 123,238 $ 98,288 $ 50,172
Total Assets $3,175,518 $ 3,122,719 $ 2,885,954 $ 2,925,937 $ 2,834,289
Long-Term Debt (3) $1,257,595 $ 1,286,320 $ 1,128,963 $ 802,804 $ 1,132,395
Non-Current Capital Lease Obligations 701,931 762,968 801,611 853,793 857,829
K-23
Common Stock Equity 580,718 556,472 456,640 441,133 385,483
- ------------------------------------------------------------------------------------------------------------------------------
Total Capitalization $2,540,244 $ 2,605,760 $ 2,387,214 $ 2,097,730 $ 2,375,707
- ------------------------------------------------------------------------------------------------------------------------------
SELECTED CASH FLOW DATA
- ------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Operating Activities $ 306,979 $ 263,396 $ 176,437 $ 215,379 $ 215,034
Capital Expenditures $ (167,017) $ (137,282) $ (112,706) $ (121,735) $ (105,996)
Other Investing Cash Flows 10,828 (213,450) (158,184) 4,888 (7,554)
- ------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Investing Activities $ (156,189) $ (350,732) $ (270,890) $ (116,847) $ (113,550)
- ------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Financing Activities $ (98,028) $ 97,674 $ (42,773) $ (33,382) $ (83,768)
- ------------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------
Ratio of Earnings to Fixed Charges (4) 1.43 1.37 1.36 1.77 1.37
- ------------------------------------------------------------------------------------------------------------------------------
(1) In 2003, Operating Revenues, Income Before Extraordinary Item and Accounting
Change and Net Income include results from UES for the period from August 11,
2003 to December 31, 2003.
(2) Net income includes an after-tax gain of $67 million for the Cumulative
Effect of Accounting Change from the adoption of FAS 143 in 2003 and $0.5
million for the Cumulative Effect of Accounting Change from the Adoption of FAS
133 in 2001.
(3) TEP's tax-exempt variable rate bonds in the amount of $329 million are
backed by LOCs issued under TEP's Credit Agreement. TEP's obligations under the
Credit Agreement are collateralized with Second Mortgage Bonds. In November
2002, TEP obtained new LOCs in the amount of $341 million to replace the LOCs
provided under its then existing Credit Agreement that would have expired on
December 30, 2002. The 2002 LOCs would have expired in 2006. Accordingly, these
IDBs were classified as short-term debt at December 31, 2001 and classified as
long-term debt at December 31, 2002. TEP entered into a new Credit Agreement in
March 2004, which provided LOCs that expire in 2009.
(4) For purposes of this computation, earnings are defined as pretax earnings
from continuing operations before minority interest, plus interest expense, and
amortization of debt discount and expense related to indebtedness. Fixed charges
are interest expense, including amortization of debt discount and expense on
indebtedness.
See Item 7. - Management's Discussion and Analysis of Financial Condition and
Results of Operations.
ITEM 6. - SELECTED CONSOLIDATED FINANCIAL DATA
- --------------------------------------------------------------------------------
TEP 2004 2003 2002 2001 2000
-------------------------------------------------------------------------------
- Thousands of Dollars -
SUMMARY OF OPERATIONS
- ------------------------------------------------------------------------------------------------------------------------------
Operating Revenues $ 889,298 $ 851,551 $ 834,447 $ 1,604,961 $ 1,031,329
Income Before Extraordinary Item and $ 46,127 $ 61,442 $ 55,390 $ 77,308 $ 52,762
Accounting Change
Net Income (1) $ 46,127 $ 128,913 $ 55,390 $ 77,778 $ 52,762
- ------------------------------------------------------------------------------------------------------------------------------
FINANCIAL POSITION
- ------------------------------------------------------------------------------------------------------------------------------
Total Utility Plant - Net $ 1,816,782 $ 1,832,156 $ 1,835,904 $ 1,832,164 $ 1,848,975
Investments in Lease Debt and Equity $ 170,893 $ 178,789 $ 191,867 $ 84,459 $ 69,474
Other Investments and Other Property $ 23,393 $ 41,285 $ 21,358 $ 21,416 $ 22,860
Total Assets $ 2,742,168 $ 2,767,047 $ 2,808,810 $ 2,824,555 $ 2,763,840
Long-Term Debt(2) $ 1,097,595 $ 1,126,320 $ 1,128,410 $ 801,924 $ 1,132,395
Non-Current Capital Lease Obligations 701,405 762,323 801,508 853,447 857,519
Common Stock Equity 414,510 406,054 353,832 337,082 307,596
- ------------------------------------------------------------------------------------------------------------------------------
Total Capitalization $ 2,213,510 $ 2,294,697 $ 2,283,750 $ 1,992,453 $ 2,297,510
- ------------------------------------------------------------------------------------------------------------------------------
K-24
SELECTED CASH FLOW DATA
- -------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Operating Activities $ 275,151 $ 260,989 $ 206,991 $ 261,169 $ 234,190
Capital Expenditures $ (129,505) $ (121,854) $ (103,307) $ (103,913) $ (98,063)
Other Investing Cash Flows 3,743 11,408 (151,035) (8,861) (23,273)
- -------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Investing Activities $ (125,762) $ (110,446) $ (254,342) $ (112,774) $ (121,336)
- -------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Financing Activities $ (101,444) $ (141,059) $ (56,551) $ (77,427) $ (112,544)
- -------------------------------------------------------------------------------------------------------------------------------
RATIO OF EARNINGS TO FIXED CHARGES (3) 1.51 1.51 1.60 1.85 1.49
- -------------------------------------------------------------------------------------------------------------------------------
(1) Net Income includes an after-tax gain of $67 million for the Cumulative
Effect of Accounting change from the Adoption of FAS 143 in 2003 and $0.5
million for the Cumulative Effect of Accounting Change from the Adoption of FAS
133 in 2001.
(2) TEP's tax-exempt variable rate bonds in the amount of $329 million are
backed by LOCs issued under TEP's Credit Agreement. TEP's obligations under the
Credit Agreement are collateralized with Second Mortgage Bonds. In November
2002, TEP obtained new LOCs in the amount of $341 million to replace the LOCs
provided under its then existing Credit Agreement that would have expired on
December 30, 2002. The 2002 LOCs would have expired in 2006. Accordingly, these
IDBs were classified as short-term debt at December 31, 2001 and classified as
long-term debt at December 31, 2002. TEP entered into a new Credit Agreement in
March 2004, which provided LOCs that expire in 2009.
(3) For purposes of this computation, earnings are defined as pre-tax earnings
from continuing operations before minority interest, plus interest expense and
amortization of debt discount and expense related to indebtedness. Fixed charges
are interest expense, including amortization of debt discount and expense on
indebtedness.
Note: Disclosure of earnings per share information for TEP is not presented as
the common stock of TEP is not publicly traded.
See Item 7. - Management's Discussion and Analysis of Financial Condition
and Results of Operations.
NON-GAAP MEASURES
ADJUSTED EBITDA
---------------
Adjusted EBITDA represents EBITDA excluding the cumulative effect of
accounting change which is a non-cash item. EBITDA is earnings before interest,
taxes, depreciation and amortization. Adjusted EBITDA is presented here as a
measure of liquidity because it can be used as an indication of a company's
ability to incur and service debt and is commonly used as an analytical
indicator in our industry. Adjusted EBITDA measures presented may not be
comparable to similarly titled measures used by other companies. Adjusted EBITDA
is not a measurement presented in accordance with United States generally
accepted accounting principles (GAAP), and we do not intend Adjusted EBITDA to
represent cash flows from operations as defined by GAAP. Adjusted EBITDA should
not be considered to be an alternative to cash flows from operations or any
other items calculated in accordance with GAAP or an indicator of our operating
performance.
UniSource Energy and TEP view Adjusted EBITDA, a non-GAAP financial
measure, as a liquidity measure. The most directly comparable GAAP measure to
Adjusted EBITDA is Net Cash Flows from Operating Activities.
ADJUSTED EBITDA AND NET CASH FLOWS FROM OPERATING ACTIVITIES
UNISOURCE ENERGY 2004 2003 2002 2001
- --------------------------------------------------------------------------------
- Millions of Dollars -
Adjusted EBITDA $ 439 $ 395 $ 366 $ 419
Net Cash Flows from Operating
Activities $ 307 $ 263 $ 176 $ 215
- --------------------------------------------------------------------------------
TEP 2004 2003 2002 2001
- --------------------------------------------------------------------------------
- Millions of Dollars -
Adjusted EBITDA $ 411 $ 403 $ 399 $ 439
Net Cash Flows from Operating
Activities $ 275 $ 261 $ 207 $ 261
- --------------------------------------------------------------------------------
K-25
RECONCILIATION OF ADJUSTED EBITDA TO CASH FLOWS FROM OPERATIONS
UNISOURCE ENERGY 2004 2003 2002 2001
- --------------------------------------------------------------------------------
- Millions of Dollars -
ADJUSTED EBITDA (1) $ 439 $ 395 $ 366 $ 419
Amounts from the Income Statements:
Less: Income Taxes (34) (12) (18) (49)
Less: Total Interest Expense (168) (167) (155) (159)
Changes in Assets and Liabilities
and Other Non-Cash Items 70 47 (17) 4
- --------------------------------------------------------------------------------
NET CASH FLOWS FROM OPERATING
ACTIVITIES $ 307 $ 263 $ 176 $ 215
================================================================================
TEP 2004 2003 2002 2001
- --------------------------------------------------------------------------------
- Millions of Dollars -
ADJUSTED EBITDA (1) $ 411 $ 403 $ 399 $ 439
Amounts from the Income Statements:
Less: Income Taxes (35) (21) (36) (58)
Less: Total Interest Expense (157) (161) (154) (158)
Changes in Assets and Liabilities
and Other Non-Cash Items 56 40 (2) 38
- --------------------------------------------------------------------------------
NET CASH FLOWS FROM OPERATING
ACTIVITIES $ 275 $ 261 $ 207 $ 261
================================================================================
(1) ADJUSTED EBITDA WAS CALCULATED AS FOLLOWS:
UNISOURCE ENERGY 2004 2003 2002 2001
---------------------------------------------------------------------------
- Millions of Dollars -
NET INCOME $ 46 $ 114 $ 35 $ 63
Amounts from the Income
Statements:
Less: Cumulative Effect of
Accounting Change - (67) - (1)
Plus: Income Taxes 34 12 18 49
Plus: Total Interest Expense 168 167 155 159
Plus: Depreciation and
Amortization 135 131 128 120
Plus: Amortization of
Transition
Recovery Asset 50 32 24 23
Plus: Depreciation included
in Fuel and Other O&M
Expense (see Note 20 of
Notes to Consolidated
Financial Statements) 6 6 6 6
---------------------------------------------------------------------------
ADJUSTED EBITDA $439 $ 395 $ 366 $ 419
===========================================================================
TEP 2004 2003 2002 2001
---------------------------------------------------------------------------
- Millions of Dollars -
NET INCOME $ 46 $ 129 $ 55 $ 78
Amounts from the Income
Statements:
Less: Cumulative Effect of
Accounting Change - (67) - (1)
Plus: Income Taxes 35 21 36 58
Plus: Total Interest Expense 157 161 154 158
Plus: Depreciation and
Amortization 117 121 124 117
Plus: Amortization of
Transition Recovery
Asset 50 32 24 23
Plus: Depreciation included in
Fuel and Other O&M
Expense (see Note 20
of Notes to Consolidated
Financial Statements) 6 6 6 6
---------------------------------------------------------------------------
ADJUSTED EBITDA $411 $ 403 $ 399 $ 439
===========================================================================
NET DEBT AND TOTAL DEBT AND CAPITAL LEASE OBLIGATIONS - TEP
- -----------------------------------------------------------
Net Debt represents the current and non-current portions of TEP's long-term
debt and capital lease obligations less investment in lease debt. We have
subtracted investment in lease debt because it represents TEP's ownership of the
debt component of its own capital lease obligations. Net Debt measures presented
may not be comparable to similarly titled measures used by other companies. Net
Debt is not a measurement presented in accordance with GAAP and we do not intend
K-26
Net Debt to represent debt as defined by GAAP. You should not consider Net Debt
to be an alternative to debt or any other items calculated in accordance with
GAAP.
AS OF DECEMBER 31, 2004 2003 2002 2001
- --------------------------------------------------------------------------------
- Millions of Dollars -
Net Debt $1,684 $1,761 $1,783 $1,921
Total Debt and Capital Lease
Obligations $1,855 $1,940 $1,975 $2,005
- --------------------------------------------------------------------------------
RECONCILIATION OF TOTAL DEBT AND CAPITAL LEASE OBLIGATIONS TO NET DEBT
AS OF DECEMBER 31, 2004 2003 2002 2001
- --------------------------------------------------------------------------------
- Millions of Dollars -
Long-Term Debt $1,098 $1,126 $1,128 $ 802
Current Portion - Long-Term Debt 2 2 2 330
- --------------------------------------------------------------------------------
TOTAL DEBT 1,100 1,128 1,130 1,132
- --------------------------------------------------------------------------------
Capital Lease Obligations 701 762 802 853
Current Portion - Capital Lease
Obligations 54 50 43 20
- --------------------------------------------------------------------------------
TOTAL DEBT AND CAPITAL LEASE
OBLIGATIONS 1,855 1,940 1,975 2,005
- --------------------------------------------------------------------------------
Investment in Lease Debt (171) (179) (192) (84)
- --------------------------------------------------------------------------------
NET DEBT $1,684 $1,761 $1,783 $1,921
================================================================================
ITEM 7. - MANAGEMENT'S DISCUSSI0N 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 strategies,
o operating results during 2004 compared with 2003, and 2003 compared
with 2002,
o factors which affect our results and outlook,
o liquidity, capital needs, capital resources, and contractual
obligations,
o dividends, and
o critical accounting estimates.
UniSource Energy is a holding company that has no significant operations of
its own. Operations are conducted by UniSource Energy's subsidiaries, each of
which is a separate legal entity with its own assets and liabilities. UniSource
Energy owns substantially all of the outstanding common stock of 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 began operations in August 2003. UES,
through its two operating subsidiaries, UNS Gas and UNS Electric, provides gas
and electric service to 30 communities in northern and southern Arizona.
Millennium invests in unregulated businesses, including Global Solar Energy
(Global Solar) a developer and manufacturer of thin-film photovoltaic cells and
modules. 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, UNS Gas, UNS Electric and
Global Solar.
TEP is the principal operating subsidiary of UniSource Energy and, at
December 31, 2004, represented approximately 84% 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 2004 include four full
quarters of operations of UNS Gas and UNS Electric. UNS Gas and UNS Electric
were not in operation during the first seven months and eleven days of 2003.
Although representing approximately 1% of UniSource Energy's total assets,
losses from Global Solar had a significant impact on earnings reported by
UniSource Energy in 2004 and 2003. Results of operations from UniSource Energy's
Other segment consist of the income and losses associated with Millennium's
other investments, excluding Global Solar; results of operations at UED, which
was established in February 2001 to oversee the development of Springerville
K-27
Unit 3; inter-company transactions; and UniSource Energy parent company
expenses. UED had a significant impact on our consolidated net income and cash
flows in the fourth quarter of 2003, as the financial closing of Springerville
Unit 3 occurred on October 21, 2003. UED operations did not have a significant
impact on net income or cash flow in 2004, nor is it expected to in future
periods.
UNISOURCE ENERGY CONSOLIDATED
OUTLOOK AND STRATEGIES
TERMINATION OF MERGER AGREEMENT
In November 2003, UniSource Energy entered into an Agreement and Plan of
Merger (the Agreement) with Saguaro Acquisition Corp. (Saguaro), an affiliate of
Saguaro Utility Group L.P. (Saguaro LP) that provided for the acquisition of all
of UniSource Energy's outstanding common stock for $25.25 per share by Saguaro.
Saguaro LP was an Arizona limited partnership whose general partner was Sage
Mountain, L.L.C. and whose limited partners included investment funds associated
with Kohlberg Kravis Roberts & Co., L.P., J.P. Morgan Partners, LLC and Wachovia
Capital Partners.
On December 21, 2004, the ACC voted, at the end of a special open meeting,
not to approve the application seeking its approval of the proposed acquisition.
The Agreement provided that in the event that the ACC denies the
acquisition, Saguaro or UniSource Energy could terminate the Agreement, and
UniSource Energy would be obligated to reimburse up to $7 million of Saguaro's
expenses. On December 30, 2004, Saguaro exercised its right to terminate the
Agreement and UniSource Energy paid Saguaro $7 million to cover Saguaro's
expenses.
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 Continue to integrate UES' businesses with UniSource Energy's other
businesses.
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 Strengthen the capital structure of TEP by using proceeds from the
UniSource Energy convertible notes, an additional debt issuance at
UniSource Energy and some of our excess cash flows to reduce TEP's
debt.
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
constructing the Tucson - Nogales transmission line, which would
improve reliability for customers of UNS Electric and could eventually
be connected to Mexico's utility system.
o Promote economic development in our service territories.
o Efficiently manage our generation, transmission and distribution
resources and look for ways to control our operating expenses while
maintaining and enhancing reliability and profitability.
o Expand TEP's portfolio of generating and purchased power resources to
meet growing retail energy demand.
o Increase production and sales of Global Solar's thin-film photovoltaic
cells and seek additional investors, or sell all or part of
Millennium's interest, or a combination of both.
o Manage the exit of our other Millennium investments to maximize its
value to shareholders.
K-28
To accomplish our goals, during 2005 we expect TEP to spend approximately
$159 million on capital expenditures and UES to spend approximately $49 million
on capital expenditures.
While we believe that our plans and strategies will continue to have a
positive impact on our financial prospects and position, we recognize that we
continue to be highly leveraged, and as a result, our access to the capital
markets may be limited or more expensive than for less leveraged companies.
RESULTS OF OPERATIONS
- ---------------------
UniSource Energy recorded Net Income of $46 million in 2004. This compares
with Net Income of $114 million in 2003, and $35 million in 2002. Net Income in
2003 includes an after-tax gain of $67 million for the Cumulative Effect of
Accounting Change from the adoption of Statement of Financial Accounting
Standards No. 143, Accounting for Asset Retirement Obligations (FAS 143). Income
Before Cumulative Effect of Accounting Change was $46 million in 2003. Results
in 2004 include a full year of operations at UNS Gas and UNS Electric; results
in 2003 were for the period August 11 to December 31.
FACTORS IMPACTING NET INCOME IN 2004 COMPARED WITH 2003
o A $196 million increase in Total Operating Revenues resulting from
additional Total Operating Revenues at UNS Gas and UNS Electric of $82
million and $89 million, respectively, and a 2.3% increase in TEP's
number of retail customers.
o Purchased Energy expense, which includes purchased power and purchased
gas expense, was higher by $118 million. This resulted from additional
Purchased Energy expense at UNS Gas and UNS Electric of $51 million
and $57 million, respectively, and a $7 million increase at TEP due to
higher economic wholesale electric purchases in lieu of running
gas-fired generation.
o Other Operations and Maintenance expense (O&M) was higher by $36
million due primarily to additional O&M at UES, $12 million of
expenses related to the proposed acquisition of UniSource Energy by
Saguaro and expenses related to planned and unplanned outages at some
of TEP's generating facilities.
o Scheduled Amortization of TEP's Transition Recovery Asset was $18
million higher than 2003.
o Total Interest Expense increased $2 million due to a full year of
interest expense at UES.
o Income Tax Expense increased $22 million in 2004 due to higher Income
Before Taxes and Cumulative Effect of Accounting Change and a $15
million tax benefit recorded in 2003 resulting from guidance issued by
the IRS clarifying rules on limitations of the use of net operating
loss carry forwards.
o Global Solar recorded a net loss of $5 million in 2004 compared with
losses of $7 million in 2003.
o Millennium's other investments recorded income of $1 million in 2004
compared with losses of $9 million in 2003.
o Results in 2003 included an $11 million pre-tax development fee
received by UED at the financial closing of Springerville Unit 3.
FACTORS IMPACTING NET INCOME IN 2003 COMPARED WITH 2002
o A $133 million increase in Total Operating Revenues resulting from
warm summer weather, a 2.2% increase in TEP's number of retail
customers, and Total Operating Revenues of $47 million at UNS Gas and
$56 million at UNS Electric.
o A $6 million decline in TEP's revenues from Electric Wholesale Sales
is primarily attributable to unplanned outages at several of TEP's
coal-fired generating facilities during the first half of 2003,
unfavorable wholesale opportunities for its gas generation resources
and record retail kWh demand in the third quarter. In addition, TEP
recorded a $2 million increase in reserves against receivables from
California wholesale sales in 2003.
K-29
o Purchased Energy expense, which includes purchased power and purchased
gas expense, was higher by $90 million. This resulted from $31 million
of Purchased Energy expense at UNS Gas and $39 million at UNS
Electric, replacement power costs in the first half of 2003 related to
planned and unplanned outages at TEP's generating facilities, and
increased economic wholesale electric purchases in lieu of running
gas-fired generation.
o Other O&M was higher by $27 million due primarily to $8 million of O&M
at UNS Gas and $6 million at UNS Electric, and increased costs
resulting from planned and unplanned outages at TEP's generating
facilities.
o Higher Total Interest Expense of $12 million related to higher
interest rates under TEP's Credit Agreement, interest expense at UNS
Gas and UNS Electric, and interest expense related to UniSource
Energy's borrowing under a bridge loan for the Citizens Acquisition.
o Despite higher Income Before Taxes and Cumulative Effect of Accounting
Change, income tax expense was $6 million less in 2003 than in 2002,
due primarily to a $15 million tax benefit resulting from guidance
issued by the IRS clarifying rules on limitations of the use of net
operating loss carry forwards.
o Expenses of $3 million related to the proposed acquisition of
UniSource Energy by Saguaro.
o UED's income in 2003 included an $11 million pre-tax development fee
received at the financial closing of Springerville Unit 3.
o 2002 results included a pre-tax coal contract termination fee of $11
million. TEP terminated a coal contract related to the Sundt
Generating Station, eliminating annual take-or-pay payments of
approximately $3 million.
CONTRIBUTION BY BUSINESS SEGMENT
The table below shows the contributions to our consolidated after-tax
earnings by our four business segments.
2004 2003 2002
- --------------------------------------------------------------------------------
-Millions of Dollars-
BUSINESS SEGMENT
TEP (1) $ 46 $ 129 $ 55
UNS Gas (2) 6 1 -
UNS Electric (2) 4 2 -
Global Solar (5) (7) (14)
Other (3) (5) (11) (6)
- --------------------------------------------------------------------------------
Consolidated Net Income $ 46 $ 114 $ 35
================================================================================
(1) TEP results in 2003 include an after-tax gain of $67 million for the
Cumulative Effect of Accounting Change from the adoption of Statement of
Financial Accounting Standards No. 143, Accounting for Asset Retirement
Obligations (FAS 143).
(2) 2003 results are for the period from August 11, 2003 to December 31, 2003.
(3) Includes: interest expense (net of tax) on the note payable from UniSource
Energy to TEP; costs in 2003 associated with the Citizens acquisition; costs
associated with the failed acquisition of UniSource Energy by Saguaro as
previously discussed; UniSource Energy parent company expenses; income and
losses from other Millennium investments; and income and losses from UED.
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
K-30
UNISOURCE ENERGY CONSOLIDATED CASH FLOWS
2004 2003 2002
-----------------------------------------------------------------------
-Millions of Dollars-
Cash Provided by (used in):
Operating Activities $ 307 $ 263 $ 176
Investing Activities (156) (351) (271)
Financing Activities (98) 98 (42)
-----------------------------------------------------------------------
Net Increase (Decrease) in Cash $ 53 $ 10 $(137)
=======================================================================
UniSource Energy's consolidated cash flows are provided primarily from
retail and wholesale energy sales at TEP and UES, net of the related payments
for fuel and purchased power. Cash from operations is lowest in the first
quarter and highest in the third quarter due to TEP's summer peaking load.
We use our available cash primarily to:
o finance capital expenditures at TEP and UES;
o pay dividends to shareholders;
o pay income taxes; and
o reduce leverage at TEP by repaying or repurchasing 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. Under our tax sharing agreement, our subsidiaries make
income tax payments to UniSource Energy, which makes payments on behalf of the
consolidated group.
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).
As of March 11, 2005, cash and cash equivalents available to UniSource
Energy was approximately $215 million. This balance includes proceeds from
UniSource Energy's Convertible Senior Notes issued March 1, 2005. See
Convertible Senior Notes, below.
OPERATING ACTIVITIES
In 2004, net cash flows from operating activities increased by $44 million
compared with 2003. The following factors contributed to the increase:
o a $114 million increase in cash receipts from retail and wholesale
energy customers, net of fuel and purchased energy costs, due to an
increase in TEP's retail customers and the recognition of a full year
of operations at UNS Gas and UNS Electric;
o the return of a $17 million deposit made in 2003 related to TEP's
second mortgage indentures; partially offset by:
- a $55 million increase in income taxes and other tax paid, net of
income tax refunds received, due primarily to higher taxable
income, higher tax refunds received in 2003, and the recognition
of a full year of operations at UNS Gas and UNS Electric;
- a $10 million increase in wages paid due to the recognition of a
full year of operations at UNS Gas and UNS Electric; and
- $7 million paid to terminate the acquisition agreement with
Saguaro.
INVESTING ACTIVITIES
Net cash used for investing activities was $195 million lower in 2004 than
in 2003, primarily due to the following factors:
o $223 million of cash used for the acquisition of the Citizens' Arizona
gas and electric utility assets in 2003; and
o a $10 million return from a Millennium investment; partially offset by
- a $16 million increase in capital expenditures, primarily
related to UNS Gas and UNS Electric;
K-31
- $13 million used by TEP to purchase a one-third interest in the
Luna Energy Facility; and
- $4 million paid by TEP to purchase Springerville lease debt.
Purchase of Citizens' Arizona Electric and Gas Utility Assets
-------------------------------------------------------------
In August 2003, UniSource Energy used approximately $50 million of its
available cash and borrowed $35 million from a financial institution in the form
of short-term debt to help finance the purchase of the Citizens' Arizona
electric and gas utility assets. The funds were used as an equity contribution
in the capitalization of UES. In October 2003, as required by the debt
agreement, UniSource Energy repaid the $35 million loan with proceeds received
upon the financial close of the Springerville Unit 3 project.
FINANCING ACTIVITIES
Net cash used for financing activities was $98 million in 2004 compared
with net cash received from financing activities of $98 million in 2003. The
following factors primarily contributed to the change:
o In August 2003, UNS Gas issued $100 million of senior unsecured notes,
UNS Electric issued $60 million of senior unsecured notes, and
UniSource Energy obtained a $35 million short-term bridge loan to help
finance the acquisition of the Citizens' Arizona gas and electric
utility assets (see Guarantees and Indemnities, below); partially
offset by:
- TEP repaid $32 million more long-term debt and capital lease
obligations in 2004 than in 2003; and
- TEP paid $9 million in debt issuance costs related to the
refinancing of its Credit Agreement.
As a result of the activities described above, our consolidated cash and
cash equivalents increased to $154 million at December 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.
At March 11, 2005, our consolidated cash balance, including cash
equivalents, was approximately $215 million. This balance includes proceeds from
UniSource Energy's Convertible Senior Notes issued March 1, 2005. See
Convertible Senior Notes, below.
In the event that we experience lower cash from operations in 2005, we will
adjust our discretionary uses of cash accordingly. We believe, however, that we
will continue to have sufficient cash flow to cover our capital needs, as well
as required debt payments and dividends to shareholders.
Convertible Senior Notes
------------------------
On March 1, 2005, UniSource Energy issued $150 million aggregate principal
amount of 4.50% Convertible Senior Notes due 2035 through a domestic offering to
qualified institutional buyers pursuant to Rule 144A under the Securities Act of
1933 (the Act) and to non-U.S. persons in offshore transactions in reliance on
Regulation S under the Act.
Each $1,000 principal amount of notes will be convertible into 26.6667
shares of UniSource Energy common stock at any time, representing a conversion
price of approximately $37.50 per share of UniSource Energy common stock,
subject to adjustment in certain circumstances.
Beginning on March 5, 2010, UniSource Energy will have the option to redeem
the notes, in whole or in part, for cash, at a price equal to 100% of the
principal amount plus accrued and unpaid interest. Holders of the notes will
have the right to require UniSource Energy to repurchase the notes, in whole or
in part, for cash on March 1, 2015, 2020, 2025 and 2030, or if certain specified
fundamental changes involving UniSource Energy occur. The repurchase price will
be 100% of the principal amount of the notes plus accrued and unpaid interest.
In the event of a fundamental change that occurs prior to March 5, 2010,
UniSource Energy may be required to pay a make-whole premium on notes converted
in connection with the fundamental change. The make-whole premium will be
payable in shares of UniSource Energy common stock or the consideration into
which UniSource Energy common stock has been converted or exchanged in
connection with such fundamental change.
A fundamental change involving UniSource Energy will be deemed to have
occurred if (1) certain transactions occur as a result of which there is a
change in control of UniSource Energy; or (2) UniSource Energy common stock
K-32
ceases to be listed on a national securities exchange or quoted on The Nasdaq
National Market or another established automated over-the-counter trading market
in the United States.
The notes may be accelerated upon the occurrence and continuance of an
event of default under the indenture governing the notes. The failure to make
required payments on the notes or comply with the terms of the indenture may
consitute an event of default. In addition, events of default may arise upon the
acceleration of $50 million of indebtedness for borrowed money of UniSource
Energy or TEP, or certain events of bankruptcy involving UniSource Energy or
TEP.
Use of Proceeds
---------------
On March 1, 2005, UniSource Energy used $106 million of the $146 million of
net proceeds from this offering to repay TEP a UniSource Energy debt obligation
in the principal amount of $95 million plus accrued interest of $11 million.
Approximately $25 million represents an equity contribution to TEP. TEP expects
that it will use the proceeds during the first half of 2005 to redeem or
repurchase certain of TEP's existing indebtedness through transactions that may
include negotiated or market purchases, tender offers and redemptions. TEP has
not determined the series of debt to be repaid or repurchased.
On March 10, 2005, UniSource Energy used $10 million of the net proceeds
from this offering to make an equity contribution of $6 million to UNS Gas and
an equity contribution of $4 million to UNS Electric.
UniSource Energy Debt Issuance
------------------------------
UniSource Energy also expects to issue approximately $90 million of
additional indebtedness. Most of the proceeds from this debt will be used to
make an equity investment in TEP. It is anticipated that this equity investment,
together with the proceeds realized through the $95 million inter-company note
repayment, will be used by TEP to retire or repurchase up to $225 million of its
outstanding debt obligations.
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 $8 million in natural gas and supply payments and
building lease payments for UNS Gas and UNS Electric, and subsidiaries of
Millennium, and Millennium's guarantee of approximately $3 million in
commodity-related payments for MEG at December 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
The following charts display UniSource Energy's consolidated contractual
obligations by maturity and by type of obligation as of December 31, 2004.
- -------------------------------------------------------------------------------------------------------------------
UNISOURCE ENERGY'S CONTRACTUAL OBLIGATIONS
- MILLIONS OF DOLLARS -
- -------------------------------------------------------------------------------------------------------------------
2011
Payment Due in Years and
Ending December 31, 2005 2006 2007 2008 2009 2010 after Total
- -------------------------------------------------------------------------------------------------------------------
Long Term Debt: (1)
Principal(2) $ 2 $ 21 $ 1 $227 $329 $ - $ 679 $1,259
Interest(3) 77 78 77 71 61 62 846 1,272
Capital Lease Obligations:
Springerville Unit 1 85 85 86 85 34 57 430 862
Springerville Coal Handling(4) 17 22 24 18 15 17 98 211
Sundt Unit 4 11 10 12 12 13 13 - 71
K-33
Springerville Common(4) 6 6 6 6 6 7 159 196
Rail Car Lease 1 - - - - - - 1
Operating Leases 2 2 2 2 1 1 4 14
Purchased Obligations:(5)
Coal and Rail Transportation(6) 89 87 79 79 79 79 278 770
Purchase Power(7) 17 4 - - - - - 21
Transmission 6 6 6 1 1 1 1 22
Gas(8) 40 26 13 4 4 4 2 93
Other Long-Term Liabilities:
Pension & Other Post-
Retirement Obligations(9) 10 4 4 5 6 6 171 206
MEH Funding Commitments(10) 2 4 1 - - - - 7
- -------------------------------------------------------------------------------------------------------------------
Total Contractual Cash Obligations $365 $ 355 $311 $510 $549 $247 $2,668 $5,005
===================================================================================================================
(1) In March 2005, TEP redeemed the remaining $52 million of its First Mortgage
IDBs (defined below) at par. $21 million was due in 2006, and $31 million was
due in 2008. Interest payments will be reduced by $3 million in 2005 and 2006
and $2 million in 2007 as a result of the bond redemption.
(2) TEP's tax-exempt variable rate bonds (IDBs) in the amount of $329 million
are backed by LOCs issued pursuant to TEP's Credit Agreement. TEP's obligations
under the Credit Agreement are collateralized with Second Mortgage Bonds.
(3) Includes letter of credit and remarketing fees on variable rate debt. The
interest rates for variable rate bonds are estimated using Eurodollar futures
rates for an approximation of LIBOR and adjusted down based on the historical
discount the bonds have had to LIBOR.
(4) Upon commercial operation of Springerville Unit 3 in December 2006,
Tri-State is obligated to reimburse TEP for various operating costs related to
the common facilities, including 14 percent of the Springerville Common Lease
payments and 17 percent of the Springerville Coal Handling Facilities Lease
payments. Similar reimbursement obligations apply if Unit 4 is constructed. TEP
remains the primary obligor under these capital leases. Capital Lease
Obligations do not reflect any reduction associated with this reimbursement.
Upon expiration of the Springerville Coal Handling Facilities and the Common
Leases, TEP is obligated to acquire the facilities at fixed prices of $139
million in 2015, $38 million in 2017 and $68 million in 2021, and each of the
owners of Unit 3 and Unit 4 (if constructed) have the obligation to purchase
from TEP a 14 percent and 17 percent interest, respectively, in such facilities.
The acquisition of the assets upon expiration of the lease terms is excluded
from the table above.
(5) Purchase obligations reflect the minimum contractual obligation under
legally enforceable contracts with contract terms that are both fixed and
determinable. The total amount paid under these contracts depends on the
quantity purchased and transported. UES and TEP's requirements are expected to
be in excess of these minimums. UniSource Energy has excluded open purchase
orders of approximately $3 million expected to be fulfilled in 2005.
(6) TEP expects to spend approximately $180 million annually for the purchase
and transportation of coal through 2010. TEP is unable to estimate how much it
will spend under these contracts beyond 2010 due to the impact of the amended
Springerville coal contract.
(7) Excludes commitments in connection with the SCE and Sempra exchange
agreements. TEP provides firm system capacity to SCE and Sempra in the winter
and spring, and firm system capacity is returned to TEP during the summer. The
agreement with SCE expires in May 2005, and the agreement with Sempra, which
commences in January 2005, extends through September 2005. Also, UniSource
Energy has not included amounts payable to PWCC under UNS Electric's full
requirements power supply agreement as payments under this contract are usage
based with no fixed demand charges and are recovered through the PPFAC
mechanism. We expect to spend approximately $92 million annually under this
contract through May 2008. Amounts also exclude TEP's swap agreements which are
marked to market on a monthly basis. TEP entered into contracts for power
purchases in 2005 totaling $8 million subsequent to December 31, 2004, which are
excluded from the table above.
(8) Amounts include UNS Gas' forward gas purchases and firm transportation
agreements with EPNG and Transwestern. Amounts also include TEP's minimum
transportation obligation with SWG. Natural gas supply and management agreement
commitments with BP are excluded as prices for incremental gas to be supplied
vary. The initial term of the contract extends through August 31, 2005, and
includes an automatic annual one year extension. UNS Gas entered into forward
gas purchases for 2007 and 2008 totaling $1 million subsequent to December 31,
2004, which are excluded from the above table.
(9) These obligations represent TEP and UES' minimum required contributions to
pension plans in 2005 and TEP's expected postretirement benefit costs to cover
medical and life insurance claims as determined by the plans' actuaries. TEP and
UES do not know and have not included pension contributions beyond 2005 due to
the significant impact that returns on plan assets and changes in discount rates
might have on such amounts. TEP funds the postretirement benefit plan on a
pay-as-you-go basis.
(10) These obligations represent Millennium's equity commitments to fund
subsidiaries (Haddington and Valley Ventures) as suitable investments are
identified.
K-34
The following obligations, incurred subsequent to December 31, 2004, are
excluded from the table above, but are included in TEP's forecasted capital
expenditures. In February 2005, TEP signed agreements to complete the
construction of Luna. TEP expects to spend up to an additional $33 million for
its one-third share of the costs of which $30 million will be spent in 2005 and
the remainder in 2006.
Under a settlement agreement signed in March 2005 with the New Mexico
Environmental Department and environmental activist groups, the co-owners of San
Juan will install new technology at the generating station to reduce mercury,
particulate matter, NOx, and SO2 emissions over the next five years. TEP's share
of the cost of new pollution control equipment based on its ownership of San
Juan is anticipated to be approximately $2 million in 2006, $8 million in 2007,
$9 million in 2008, $5 million in 2009, $3 million in 2010 and $1 million in
2011.
MEG conducts its emissions and coal trading activities using certain
contracts which contain provisions whereby MEG may be required to post margin
collateral due to a change in contract values. As of December 31, 2004, MEG had
no cash collateral posted to its trading counterparties.
In September 2004, MEG reduced its bank line of credit from $5 million to
$3 million. The purpose of this line of credit is to issue LOCs to
counterparties to support its emission allowance and coal marketing and trading
activities. As of December 31, 2004, MEG had $2 million in outstanding LOCs, all
of which had expired by the end of February 2005. This facility expired in March
2005 and will not be renewed.
In addition, UniSource Energy has contingent obligations under various
surety bonds that total approximately $0.5 million.
We have reviewed our contractual obligations and provide the following
additional information:
o We do not have any provisions in any of our debt or lease agreements
that would cause an event of default or cause amounts to become due
and payable in the event of a credit rating downgrade.
o None of our contracts or financing structures contains provisions or
acceleration clauses due to changes in our stock price.
DIVIDENDS ON COMMON STOCK
On February 4, 2005, UniSource Energy declared a cash dividend of $0.19 per
share on its Common Stock. The dividend, totaling approximately $7 million, was
paid March 8, 2005 to shareholders of record at the close of business February
15, 2005. During 2004, UniSource Energy paid quarterly dividends to its
shareholders of $0.16, totaling approximately $22 million. In 2003, we paid
quarterly dividends of $0.15 per share, totaling approximately $20 million.
INCOME TAX POSITION
At December 31, 2004, UniSource Energy and TEP had, for federal and state
income tax filing purposes, the following carry forward amounts:
UNISOURCE ENERGY TEP
Amount Expiring Amount Expiring
-Millions of Dollars- Year -Millions of Dollars- Year
- ------------------------------------------------------------------------------------------------------
NET OPERATING LOSSES $ 18 2021-2022 $ - -
INVESTMENT TAX CREDIT 5 2004-2024 5 2004-2024
AMT CREDIT 100 - 92 -
- -------------------------------------------------------------------------------------------------------
The $18 million in NOL carry forwards is subject to limitation due to a
reorganization of certain Millennium entities in December 2002. The future use
of these losses is dependent upon the generation of sufficient future taxable
income at the separate company level. See Critical Accounting Estimates,
Deferred Tax Valuation - TEP and Millennium, below.
TUCSON ELECTRIC POWER COMPANY
K-35
RESULTS OF OPERATIONS
- ---------------------
The financial condition and results of operations of TEP are currently the
principal factors affecting the financial condition and results of operations of
UniSource Energy on an annual basis. The following discussion relates to TEP's
utility operations, unless otherwise noted.
UTILITY SALES AND REVENUES
Customer growth, weather and other consumption factors affect retail sales
of electricity. Electric wholesale revenues are affected by market prices in the
wholesale energy market, availability of TEP generating resources, and the level
of wholesale forward contract activity.
The table below provides trend information on retail sales by major
customer class and electric wholesale sales made by TEP in the last three years,
as well as weather data for TEP's service territory.
SALES OPERATING REVENUE
2004 2003 2002 2004 2003 2002
- ------------------------------------------------------------------------------------------------------------
-Millions of kWh- -Millions of Dollars-
ELECTRIC RETAIL SALES:
Residential 3,460 3,390 3,181 $ 315 $ 310 $ 291
Commercial 1,788 1,689 1,605 187 176 169
Industrial 2,226 2,245 2,254 161 160 162
Mining 829 702 693 39 28 28
Public Authorities 240 250 257 17 18 19
- ------------------------------------------------------------------------------------------------------------
TOTAL ELECTRIC RETAIL SALES 8,543 8,276 7,990 719 692 669
- ------------------------------------------------------------------------------------------------------------
ELECTRIC WHOLESALE SALES
DELIVERED:
Long-term Contracts 1,227 1,199 982 33 31 29
Other Sales 2,065 2,165 3,035 121 115 125
Transmission - - - 5 6 4
Net Unrealized Gain (Loss) on
Forward Sales of Energy - - - 1 (1) (1)
- ------------------------------------------------------------------------------------------------------------
TOTAL ELECTRIC WHOLESALE SALES 3,292 3,364 4,017 160 151 157
- ------------------------------------------------------------------------------------------------------------
TOTAL ELECTRIC SALES 11,835 11,640 12,007 $ 879 $ 843 $ 826
============================================================================================================
WEATHER DATA:
Cooling Degree Days 1,298 1,567 1,439
10-Year Average 1,409 1,458 1,442
%Over/(Under)Prior Year (17%) 9% (3%)
%Over/(Under)10-Year Average (8%) 7% (1%)
Heating Degree Days 1,631 1,327 1,440
10-Year Average 1,481 1,459 1,462
%Over/(Under)Prior Year 23% (8%) (16%)
%Over/(Under)10-Year Average 10% (9%) (1%)
- ------------------------------------------------------------------------------------------------------------
2004 COMPARED WITH 2003
Total revenues from kWh sales to retail customers increased by $28 million,
or 4%, in 2004, resulting from higher energy demand. Total retail kWh sales
increased by 3% in 2004, despite mild summer weather. Cooling degree days were
17% lower than 2003 and 8% below the 10-year average. Kilowatt-hour sales to
residential customers were 2% higher, while kWh sales to commercial customers
were 6% higher, resulting from customer growth of 2.3% and cool winter weather.
Heating degree days were 23% higher than 2003 and 10% above the 10-year average.
The average price of copper was 59% higher in 2004, leading to increased mining
activity and an 18% increase in kWh sales to TEP's mining customers; revenues
from TEP's mining customers increased $11 million.
Wholesale revenues increased $9 million, or 6%, in 2004, despite a 2%
decrease in wholesale kWh sales. In the first nine months of 2004, TEP benefited
from greater coal plant availability which allowed TEP to sell more excess power
into the wholesale market compared to last year. Wholesale sales opportunities
were limited in the fourth quarter of 2004 due to a planned outage at TEP's
Springerville Unit 1. The average wholesale market price of energy was $44 per
MWh in 2004, compared with $41 per MWh in 2003. See Factors Affecting Results of
Operations, Western Energy Markets, Market Prices, below.
K-36
TEP recorded a $3 million reserve in the second quarter of 2004 and a $2
million reserve in the first quarter of 2003 for revenue subject to refund
related to wholesale sales made to the California Independent System Operator
(CISO) and the California Power Exchange (CPX) in 2001 and 2000. These amounts
are recorded as a reduction to wholesale revenue.
2003 COMPARED WITH 2002
Total retail kWh sales in 2003 increased by 4% compared with 2002. Warmer
summer weather and a 2.2% increase in the number of retail customers more than
offset mild weather during the first six months of 2003. Kilowatt-hour sales to
residential customers were up 7% and kWh sales to commercial customers were up
5% in 2003, resulting from customer growth and warmer weather compared with a
year ago. Revenue from sales to retail customers increased by 3% in 2003,
reflecting higher kWh demand.
Electric wholesale revenues decreased by 4% in 2003. The 4% decline in
wholesale revenues is not as large as the 16% decline in wholesale kWh sales due
to higher average power prices. Average-around-the-clock energy prices based on
the Dow Jones Palo Verde Index for 2003 were $42 per MWh compared with $27 per
MWh during 2002, reflecting higher gas prices. Planned and unplanned outages at
TEP's coal-fired generating plants, particularly in the first six months of
2003, reduced opportunities to sell excess power in the wholesale markets. In
addition, the increase in the regional supply of gas-generated energy allowed
TEP to decrease use of its less efficient gas generation units for wholesale
market opportunities.
Wholesale revenues were reduced by a $2 million reserve for doubtful
accounts in 2003, related to wholesale sales made to CISO and CPX in 2001 and
2000.
OPERATING EXPENSES
2004 COMPARED WITH 2003
FUEL AND PURCHASED POWER EXPENSE
TEP's fuel and purchased power expense, and energy resources for 2004, 2003
and 2002 are detailed below:
GENERATION EXPENSE
2004 2003 2002 2004 2003 2002
- ------------------------------------------------------------------------------------------------------------
-Millions of kWh- -Millions of Dollars-
Coal-Fired Generation 10,894 10,826 10,756 $ 179 $ 178 $ 178
Gas-Fired Generation 440 439 713 34 32 32
- ------------------------------------------------------------------------------------------------------------
Total Generation 11,334 11,265 11,469 213 210 210
Purchased Power 1,322 1,153 1,330 72 65 43
- ------------------------------------------------------------------------------------------------------------
Total Resources 12,656 12,418 12,799 $ 285 $ 275 $ 253
========================================
Less Line Losses and Company Use 821 778 792
- --------------------------------------------------------------------
Total Energy Sold 11,835 11,640 12,007
====================================================================
Fuel expense at TEP's generating plants was $213 million in 2004 compared
with $210 million in 2003. Gas-related fuel expense increased $2 million to $34
million, in 2004 due to an 11% increase in market price for gas. Coal-related
fuel expense increased $1 million due to the higher availability and use of
TEP's coal-fired generating plants. See Factors Affecting Results of Operations,
Western Energy Markets, Market Prices, below.
The table below shows the average cost per kWh for TEP's generating plants
by fuel type.
2004 2003 2002
------------------------------------------------------------
-cents per kWh-
Coal 1.64 1.65 1.65
Gas 7.86 7.40 4.45
All fuels 1.88 1.87 1.83
------------------------------------------------------------
K-37
The increase in the regional supply of new gas-generated energy and the
completion of a 500-kV transmission connection allowed TEP to decrease use of
its older, less efficient gas generation units in favor of more economical
purchases of energy in the wholesale market. TEP's Purchased Power expense
increased approximately $7 million, or 11% in 2004.
OTHER OPERATING EXPENSES
Other Operations and Maintenance expense increased by $20 million, or 12%,
in 2004 primarily attributable to increased maintenance costs at the
Springerville and San Juan generating facilities and approximately $8 million of
costs related to the proposed acquisition of UniSource Energy by Saguaro.
Amortization of the Transition Recovery Asset (TRA) increased $18 million
in 2004 compared with 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.
The table below shows estimated TRA amortization and unamortized TRA
balances for 2005-2008.
FUTURE ESTIMATED UNAMORTIZED
TRA AMORTIZATION TRA BALANCE
-Millions of Dollars-
------------------------------------------------------------
2005 $ 57 $ 168
2006 66 102
2007 76 26
2008 26 -
------------------------------------------------------------
OTHER INCOME (DEDUCTIONS)
TEP's Income statement includes inter-company Interest Income of $9 million
for 2004, and $10 million for 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
Consolidated Statement of Income, this Interest Income, as well as UniSource
Energy's related interest expense, is eliminated as an inter-company
transaction.
INTEREST EXPENSE
Long-Term Debt Interest Expense decreased by $5 million, or 6%, in 2004 due
to lower Letter of Credit fees under TEP's Credit Agreement entered into in
March 2004 and lower interest expense related to the $27 million of 8.5% First
Mortgage Bonds redeemed in July 2004. Interest on Capital Leases increased $2
million in 2004 due to a recalculation of interest expense related to a
capitalized lease transaction.
INCOME TAX EXPENSE
Income Tax Expense Before Cumulative Effect of Accounting Change increased
$14 million in 2004 compared with 2003, due primarily to a $15 million tax
benefit recognized in 2003 resulting from guidance issued by the IRS clarifying
rules on limitations of the use of net operating loss carry forwards.
2003 COMPARED WITH 2002
FUEL AND PURCHASED POWER EXPENSE
Fuel expense at TEP's generating plants was approximately $210 million in
both 2003 and 2002.
TEP's Purchased Power expense increased approximately $22 million, or 51%,
in 2003. In addition to energy purchases made during the third quarter of 2003,
TEP purchased replacement power during the first half of 2003 due to planned and
unplanned outages at some of its generating facilities.
K-38
OTHER OPERATING EXPENSES
Other Operations and Maintenance expense increased by $7 million, or 4%, in
2003 primarily attributable to unplanned outages and longer-than-expected
planned outages at some of TEP's generating facilities during the first quarter
of 2003.
Depreciation and Amortization expense decreased $3 million in 2003. The
adoption of FAS 143 in the first quarter of 2003 resulted in a $6 million
decrease because asset retirement costs are no longer recorded as a component of
depreciation expense. See Critical Accounting Estimates, Accounting for Asset
Retirement Obligations, above.
Amortization of the TRA increased $7 million in 2003 compared with 2002.
OTHER INCOME (DEDUCTIONS)
TEP's income statement includes inter-company Interest Income of $10
million for 2003, and $9 million for 2002. This Interest Income, as well as
UniSource Energy's related interest expense, is eliminated as an inter-company
transaction.
INTEREST EXPENSE
Long-Term Debt Interest Expense increased by $11 million, or 17%, in 2003
due to higher Letter of Credit fees under TEP's Credit Agreement entered into in
November, 2002. Interest on Capital Leases decreased $4 million in 2003 due to
scheduled repayments of lease debt.
INCOME TAX EXPENSE
Income Tax Expense, before Cumulative Effect of Accounting Change,
decreased $15 million in 2003 compared with 2002, due primarily to a $15 million
tax benefit resulting from guidance issued by the IRS clarifying rules on
limitations of the use of net operating loss carry forwards.
CUMULATIVE EFFECT OF ACCOUNTING CHANGE
TEP adopted FAS 143 on January 1, 2003 and recorded a one-time $67 million
after-tax gain. Upon adoption of FAS 143, TEP recorded an asset retirement
obligation of $38 million at its net present value of $1 million, increased
depreciable assets by $0.1 million for asset retirement costs, reversed $113
million of costs previously accrued for final removal recorded in accumulated
depreciation, and reversed previously recorded deferred tax assets of $44
million. Adopting FAS 143 results in a reduction to depreciation expense charged
throughout the year as well because asset retirement costs are no longer
recorded as a component of depreciation expense. For the year 2003, the
reduction in depreciation expense is approximately $6 million. See Critical
Accounting Estimates, 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 recent experience in California
with deregulation has caused many states, including Arizona, to re-examine the
viability of retail electric deregulation.
As of January 1, 2001, all of TEP's retail customers are eligible to choose
an alternate energy supplier. Currently none of TEP's retail customers are
receiving service from other providers. 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.
In January 2005, an Arizona Court of Appeals decision became final in which
the Court held invalid certain portions of the ACC rules on retail competition
and related market pricing. Based on this decision, we expect that the ACC will
address the competition rules in an administrative proceeding during 2005. We
cannot predict what changes, if any, the ACC will make to the competition rules.
K-39
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'S SETTLEMENT AGREEMENT AND RETAIL ELECTRIC COMPETITION RULES
In September 1999, the ACC approved the Retail Electric Competition Rules
(Rules) that provided a framework for the introduction of retail electric
competition in Arizona. In November 1999, the ACC approved the Settlement
Agreement between TEP and certain customer groups related to the implementation
of retail electric competition in Arizona.
The Rules and the Settlement Agreement established:
o a period, November 1999 through 2008, for TEP to transition its
generation assets from a cost of service based rate structure to a
market, or competitive, rate structure;
o the recovery through rates during the transition period of $450
million of stranded generation costs through a fixed competitive
transition charge (fixed CTC);
o capped rates for TEP retail customers through 2008;
o an ACC interim review of TEP retail rates in 2004;
o unbundling of electric services with separate rates or prices for
generation, transmission, distribution, metering, meter reading,
billing and collection, and ancillary services;
o a process for Energy Service Providers (ESPs) to become licensed by
the ACC to sell generation services at market prices to TEP retail
customers;
o access for TEP retail customers to buy market priced generation
services from ESPs beginning in 2000 (currently, no TEP customers are
purchasing generation services from ESPs);
o transmission and distribution services would remain subject to
regulation on a cost of service basis; and
o beginning in 2009, TEP's generation would be market based and its
retail customers would pay the market rate for generation services.
Recent Court Action
-------------------
In January 2005, an Arizona Court of Appeals decision became final in which
the Court held invalid certain portions of the ACC rules on retail competition
and related market pricing. Based on this decision, we cannot predict what
changes, if any, the ACC will make to the Rules and how this decision might
ultimately impact our Settlement Agreement.
2004 General Rate Case Information
----------------------------------
On June 1, 2004, as required by the Settlement Agreement, TEP filed general
rate case information with the ACC. TEP's filing does not propose any change in
retail rates, and under the terms of the Settlement Agreement, no rate case
filed by TEP through 2008 may result in a net rate increase. However, absent the
restriction on raising rates, TEP believes that the data in its filing would
justify an increase in retail rates of 16%.
The general rate case information uses a historical test year ended
December 31, 2003 and establishes, based on TEP's standard offer service, that
TEP is experiencing a revenue deficiency of $111 million. The rate case
information includes, among other things, Springerville Unit 1 costs and other
generation costs including fuel cost in excess of those recovered through
existing rates. The proposed weighted cost of capital for the test year ended
December 31, 2003 is 8.78%, including an 11.5% return on equity (increased from
10.67% currently authorized). The rate case information uses a hypothetical 40%
equity capitalization (excluding capital lease obligations) rather than the
hypothetical 37.5% equity capitalization used in TEP's last general rate case.
TEP's actual equity capitalization (excluding capital lease obligations) at
December 31, 2004 was 27%. In the first half of 2005, TEP expects to increase
common equity to 40% of capitalization (excluding capital lease obligations).
See TEP, Dividends on Common Stock, below for further information regarding
improvements to TEP's capital structure. Despite
K-40
the indicated revenue deficiency, the ACC could conclude that TEP should
decrease rates after June 1, 2005; any such determination would be strongly
opposed by TEP.
A procedural order was issued in February 2005 that outlined how the review
of TEP's general rate case information will proceed. The schedule calls for
staff and intervenor testimony to be filed by June 13, 2005 and hearings, as
appropriate, before the administrative law judge to begin September 12, 2005.
Transition
----------
The Settlement Agreement provides that TEP's fixed CTC will expire when
TEP's $450 million transition asset is fully amortized and recovered or on
December 31, 2008, whichever is earlier. Based on current projections of retail
sales, the transition recovery asset is expected to be fully amortized by
mid-2008. The Settlement Agreement also specifies that TEP's floating
competitive transition charge (floating CTC) will expire on December 31, 2008.
This charge, which moves inversely to changes in market-based generation
services rates, presently appears as a credit on retail customer bills. Based on
current forward pricing in the wholesale energy markets, TEP anticipates that
the floating CTC will continue to appear as a credit on retail customer bills
through 2008. After the expiration of the floating CTC, TEP's rates for
generation services should be market based. TEP anticipates that it will submit
a rate filing to address the rates that will go into effect after the expiration
of the 1999 Settlement Agreement.
Absent any other change to TEP's retail rate structure, including continued
inability to recover actual costs, TEP estimates that the expiration of the
fixed CTC in 2008 (which has provided revenues, on average of .93 cents per kWh
sold) would result in an average decrease in revenues from retail rates of
approximately 12% relative to revenues from current retail rates. However,
absent any other change except the expiration of the fixed CTC, the expiration
in 2008 of the floating CTC would result in market-based generation services
rates which would, based on current pricing in the wholesale energy markets,
produce a retail rate increase in January 2009 of approximately 10-15% relative
to current retail rates.
Given the recent court action described above, the ACC may revise its Rules
and rate methodologies prior to the expiration in 2008 of the Settlement
Agreement. A new structure could replace that established pursuant to the
Settlement Agreement prior to January 2009.
We are operating pursuant to the Settlement Agreement. However, we cannot
predict the future rate methodologies for TEP which the ACC could authorize,
including whether the ACC will permit or require market-based rates for
generation services, reinstate cost of service ratemaking for all or a portion
of TEP's generation services or require an alternate methodology to determine
rates for TEP's generation services. Under any circumstances, TEP will seek
appropriate recovery and return on its investment in assets used to serve its
customers.
In the event that the ACC reinstates cost of service ratemaking for TEP's
generation services and does not allow other factors that have changed in the
intervening years to be considered, significant retail rate decreases could
occur. TEP expects that, in establishing future rates, TEP and the ACC will
review the entirety of the retail rate structure rather than focusing solely on
any one of the elements noted above. Although TEP is unable to predict the type
and level of future retail rates, TEP believes that the 2004 general rate case
information filed with the ACC evidences that there have been a number of
factors that have changed since the Settlement Agreement was approved that
justify increasing or maintaining retail rates at current levels.
WESTERN ENERGY MARKETS
As a participant in the western U.S. wholesale power markets, TEP is
directly and indirectly affected by changes in market conditions and market
participants. TEP competes with other utilities, power marketers and independent
power producers in the sale of electric capacity and energy at market-based
rates in the wholesale market.
As of the end of 2004, electric generating capacity in Arizona has grown to
approximately 25,000 MW; an increase of nearly 60% since 2001. A majority of the
growth over the last three years is the result of 16 new or upgraded gas-fired
generating units with a combined capacity of approximately 9,200 MW. In
addition, the presence of fewer creditworthy counterparties, as well as legal,
political and regulatory uncertainties, has reduced market liquidity and trading
volume.
K-41
MARKET PRICES
The average market price for around-the-clock energy based on the Dow Jones
Palo Verde Index increased in 2004 compared with 2003, as did the average price
for natural gas based on the Permian Index. Average market prices for
around-the-clock energy began to rise back in February 2003 and stayed at these
elevated levels during 2004 due to high natural gas prices from increased demand
and production and storage level concerns. As a result of all of these factors,
TEP's natural gas and purchased power expenses were higher in 2004 than in 2003.
Prices have continued in this range to date; however, 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 during 2005.
AVERAGE MARKET PRICE FOR AROUND-THE-CLOCK ENERGY $/MWH
-----------------------------------------------------------------------
Quarter ended December 31, 2004 $ 46
Quarter ended December 31, 2003 38
12 months ended December 31, 2004 44
12 months ended December 31, 2003 41
-----------------------------------------------------------------------
AVERAGE MARKET PRICE FOR NATURAL GAS $/MMBTU
-----------------------------------------------------------------------
Quarter ended December 31, 2004 $ 5.90
Quarter ended December 31, 2003 4.05
12 months ended December 31, 2004 5.44
12 months ended December 31, 2003 4.92
-----------------------------------------------------------------------
TEP typically uses generation from its facilities fueled by natural gas and
purchased power, in addition to energy from its coal-fired facilities, to meet
the summer peak demands of its retail customers and to meet local reliability
needs. Some of these purchased power contracts are price indexed to natural gas
prices. Short-term and spot power purchase prices are also closely correlated to
natural gas prices. Due to its increasing seasonal gas and purchased power
usage, TEP hedges a portion of its total natural gas exposure from plant fuel,
gas-indexed purchased power and spot market purchases with fixed price contracts
for a maximum of three years. TEP purchases its remaining gas fuel needs and
purchased power in the spot and short-term markets.
TEP entered into a Gas Procurement Agreement with SWG effective June 1,
2001 with a primary term of five years. The contract provided for a minimum
volume obligation during the first two years of 10 million MMBtus annually. TEP
negotiated new pricing and a lower minimum annual volume obligation of 4 million
MMBtus for 2004 and subsequently for 2005. In 2004, TEP purchased 5.2 million
MMBtus of gas and expects to use more than the minimum in 2005. In the event
fewer MMBtus are purchased, TEP is obligated to pay only the transportation
component for any shortfall. TEP made payments under this contract, which
include transportation charges, of $34 million in 2004, $34 million in 2003 and
$33 million in 2002. In 2004, the average transportation cost per MMBtu was
$0.43, or $2 million, based on the volume of gas TEP purchased.
We expect the market price and demand for capacity and energy to continue
to be influenced by factors including:
o weather;
o continued population growth in the western U.S.;
o economic conditions in the western U.S.;
o availability of generating capacity throughout the western U.S.;
o the extent of electric utility industry restructuring in Arizona,
California and other western states;
o the effect of FERC regulation of wholesale energy markets;
o the availability and price of natural gas;
o availability of hydropower;
o transmission constraints; and
o environmental regulations and the cost of compliance.
LIQUIDITY AND CAPITAL RESOURCES
K-42
TEP CASH FLOWS
TEP's capital requirements consist primarily of capital expenditures and
optional and mandatory redemptions of long-term debt and capital lease
obligations. As shown in the chart below, during the last three years, TEP had
sufficient cash available after capital expenditures, scheduled debt payments
and capital lease obligations to provide for other investing and financing
activities:
2004 2003 2002
------------------------------------------------------------------------------
-Millions of Dollars-
Cash from Operations $ 275 $ 261 $ 207
Capital Expenditures (116) (122) (103)
Capital Expenditures for Luna Energy (13) - -
Facility Assets
------------------------------------------------------------------------------
Net Cash Flows after Capital Expenditures 146 139 104
------------------------------------------------------------------------------
Debt Maturities (2) (2) (2)
Retirement of Capital Lease Obligations (49) (43) (20)
Proceeds from Investment in
Springerville Lease Debt and Equity 12 12 3
------------------------------------------------------------------------------
Net Cash Flows Available after Required
Payments $ 107 $ 106 $ 85
==============================================================================
During 2005, TEP expects to generate sufficient internal cash flows to fund
its operating activities, construction expenditures, required debt maturities,
and to pay dividends to UniSource Energy. However, TEP's cash flows may vary due
to changes in wholesale revenues, changes in short-term interest rates, and
other factors. TEP currently has $60 million available under its Revolving
Credit Facility which it may borrow if cash flows fall short of expectations or
if monthly cash requirements temporarily exceed available cash balances.
OPERATING ACTIVITIES
In 2004, net cash flows from operating activities increased by $14 million
compared with 2003. The following factors contributed to the increase:
o a $29 million increase cash receipts from retail and wholesale
electric customers, net of fuel and purchased energy costs, due
primarily to higher retail energy demand;
o the return of a $17 million deposit made in 2003 related to TEP's
second mortgage indenture; and
o a $12 million decrease in total interest paid due primarily to lower
interest rates on TEP's Credit Facility, which was refinanced in March
2004, and lower capital lease obligations outstanding; partially
offset by:
- a $20 million receipt of interest in 2003 related to the
inter-company note to UniSource Energy;
- a $31 million increase in income taxes and other tax paid, net of
income tax refunds received, due to higher estimated taxable
income for 2004 and higher tax refunds received in 2003;
- a $5 million increase in wages paid due to higher incentive
compensation.
In January 2004, TEP borrowed $20 million under its revolving credit
facility and repaid it within 30 days. At December 31, 2004, there were no
outstanding borrowings under the revolving credit facility.
INVESTING ACTIVITIES
Net cash used for investing activities was $15 million higher in 2004
compared with 2003, due primarily to the purchase of the Luna Energy Facility
for $13 million and a $4 million investment in Springerville Lease Debt. These
expenditures were partially offset by $4 million of lower capital expenditures
at TEP, primarily the result of the timing of expected projects. We expect TEP's
capital expenditures to be approximately $159 million in 2005. TEP's capital
budget is established annually; however, it is subject to change as
opportunities and requirements arise related to our service territory.
Investments in Springerville Lease Debt and Equity
--------------------------------------------------
PRINCIPAL AVERAGE
DATE AMOUNT DEBT PURCHASED COUPON RATE
- --------------------------------------------------------------------------------
K-43
January 2002 $96 million Springerville Coal Handling Lease Debt 14.3%
May 2002 3 million Springerville Unit 1 Lease Debt 10.7%
September 2002 33 million Springerville Unit 1 Lease Debt 10.6%
March 2004 4 million Springerville Unit 1 Lease Debt 10.7%
- --------------------------------------------------------------------------------
As of March 11, 2005, TEP's total investment in Springerville Lease Debt
was approximately $163 million, at yields at date of purchase ranging from 8.9%
to 12.7%.
See Note 10 of Notes to Consolidated Financial Statements - Debt and
Capital Lease Obligations
Capital Expenditures
--------------------
TEP's forecasted capital expenditures for the next five years are: $159
million in 2005, $141 million in 2006, $133 million in 2007, $124 million in
2008, and $198 million in 2009. Forecasted capital expenditures for 2009 include
$54 million of additional local generation facilities to support anticipated
growth in TEP's service territory. These estimated capital expenditures for
2005-2009 break down in the following categories:
o $447 million for transmission, distribution and other facilities;
o $158 million for production facilities;
o $54 million for new generation in service in 2010;
o $36 million for the Luna Energy Facility;
o $35 million for environmental projects; and
o $25 million for renewable energy projects, including the expansion of
TEP's solar generation portfolio.
These estimated expenditures include costs for TEP to comply with current
federal and state environmental regulations. All of these estimates are subject
to continuing review and adjustment. Actual construction expenditures may be
different from these estimates due to changes in business conditions,
construction schedules, environmental requirements, and changes to TEP's
business arising from retail competition. TEP plans to fund these expenditures
through internally generated cash flow.
If TEP obtains the required environmental permits to proceed with the
planned transmission line to Nogales, it would expect to fund an additional $76
million during this five year period to complete the line. See Item 1. Business,
Tucson Electric Utility Operations, Transmission Access, Tucson to Nogales
Transmission Line.
In addition to TEP's forecasted capital expenditures for construction,
TEP's other capital requirements include its required debt maturities and
capital lease obligations. See Note 10 of Notes to Consolidated Financial
Statements - Debt and Capital Lease Obligations.
FINANCING ACTIVITIES
Net cash used for financing activities was $40 million lower in 2004
compared with 2003. The following factors contributed to the decrease:
o a decrease of $49 million in dividends paid by TEP to UniSource
Energy; and
o an increase in other net cash inflows of $33 million due primarily to
an $11 million decrease in inter-company tax payments to UniSource
Energy and an increase of $5 million from inter-company transactions
with UES; partially offset by,
o $34 million more in payments by TEP for long-term debt and capital
lease obligations in 2004 than in 2003; and
o $9 million paid in debt issuance costs related to the refinancing of
its Credit Agreement.
K-44
Inter-Company Note from UniSource Energy
----------------------------------------
On March 1, 2005, UniSource Energy repaid to TEP a debt obligation in the
principal amount of $95 million plus accrued interest of $11 million. TEP
expects that it will use the proceeds during the first half of 2005 to redeem or
repurchase certain of its existing indebtedness through transactions that may
include negotiated or market purchases, tender offers and redemptions. TEP has
not determined the series of debt to be repaid or repurchased.
Bond Issuance and Redemption
----------------------------
In July 2004, TEP redeemed the remaining $27 million of its 8.5% First
Mortgage Bonds which were due in 2009. TEP paid a premium of $0.4 million
related to this redemption. A portion of this premium was expensed immediately,
while the remainder is being amortized over the original life of the bonds.
During 2004, TEP also made required sinking fund payments of $2 million. During
2003, TEP purchased and retired $0.4 million of its 8.50% First Mortgage Bonds
due in 2009 and made required sinking fund payments of $2 million.
In March 2005, TEP redeemed $21 million of its 7.5% First Mortgage Bonds at
par, which were due in 2006. TEP also redeemed in March 2005 $31 million of its
6.1% First Mortgage Bonds at par, which were due in 2008.
Capital Lease Obligations
-------------------------
At December 31, 2004, TEP had $755 million of total capital lease
obligations on its balance sheet. The table below provides a summary of the
outstanding lease amounts at December 31, 2004.
BALANCE AT
LEASED ASSET 12/31/2004 EXPIRATION
- --------------------------------------------------------------------------------
- In Millions -
Springerville Unit 1 $ 460 2014
Springerville Coal Handling Facilities 126 2015
Springerville Common Facilities 105 2020
Sundt Unit 4 63 2010
Other Leases 1 2006
- -------------------------------------------------------------------
Total Capital Lease Obligations $ 755
===================================================================
TEP will not own these assets at the expiration of the lease. TEP may renew
the leases or purchase the leased assets at such time. These renewal and
purchase options are generally for fair market value as determined at that time.
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 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 Credit Agreement also provides that under certain
circumstances, certain regulatory actions could result in a required reduction
of the commitments. As of December 31, 2004, TEP was in compliance with the
terms of the Credit Agreement.
K-45
Upon the occurrence and continuance of an event of default under the Credit
Agreement, outstanding borrowings under the Credit Agreement may become
immediately due and payable. Events of default under the Credit Agreement
include failure to make payments required thereunder, certain events of
bankruptcy or commencement of similar liquidation or reorganization proceedings
or a change of control of TEP. In addition, an event of default may occur if TEP
or certain specified subsidiaries fail to make when due any payment of principal
(regardless of amount) in respect of certain indebtedness the aggregate
principal amount of which exceeds $15 million or if any such indebtedness
becomes due or capable of being called for payment prior to its scheduled
maturity.
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%. 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
were 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. Fees of $9 million associated with the entry into the new facility
are being amortized through June 2009. This expense is included in Long-Term
Debt Interest Expense in UniSource Energy and TEP's income statements.
At December 31, 2004, TEP had no outstanding borrowings under the revolving
credit 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%.
TEP also pays a commitment fee of 0.50% on the unused portion of the revolving
credit facility.
TEP expects to refinance its current Credit Agreement in the first half of
2005.
Springerville Common Facilities Leases
--------------------------------------
In 1985, TEP sold and leased back its undivided one-half ownership interest
in the common facilities at the Springerville Generating Station. Under the
terms of the Springerville Common Facilities Leases, TEP must periodically
arrange for refinancing or refunding of the secured notes underlying the leases
prior to the named date in order to avoid a special event of loss. TEP was
required to arrange for the refinancing of the lease debt prior to the special
event of loss date of June 30, 2003 or the leases would have been terminated and
TEP would have been required to repurchase the facilities for $125 million.
TEP finalized the arrangements for the refinancing of $70 million of lease
debt on June 26, 2003 and the special event of loss date was reset for June 30,
2006. Interest on the new debt is payable at LIBOR plus 4.25%. The LIBOR rate is
reset every six months and the rate in effect on December 31, 2004 was 1.92%,
and was 0.99% on December 31, 2003, which resulted in a total interest rate on
the lease debt of 6.17% at December 31, 2004 and 5.24% at December 31, 2003.
Prior to the refinancing, the interest rate was LIBOR plus 2.50%. TEP will be
required to arrange for the refinancing of the lease debt prior to the special
event of loss date of June 30, 2006 or TEP will be required to repurchase the
facilities for approximately $127 million.
Tax-Exempt Local Furnishing Bonds
---------------------------------
TEP has financed a substantial portion of utility plant assets with
industrial development revenue bonds issued by the Industrial Development
Authorities of Pima County and Apache County. The interest on these bonds is
excluded from gross income of the bondholder for federal tax purposes. This
exclusion is allowed because the facilities qualify as "facilities for the local
furnishing of electric energy" as defined by the Internal Revenue Code. These
bonds are sometimes referred to as "tax-exempt local furnishing bonds." To
qualify for this exclusion, the facilities must be part of a system providing
electric service to customers within not more than two contiguous counties. TEP
provides electric service to retail customers in the City of Tucson and certain
other portions of Pima County, Arizona and to Fort Huachuca in contiguous
Cochise County, Arizona.
TEP has financed the following facilities, in whole or in part, with the
proceeds of tax-exempt local furnishing bonds: Springerville Unit 2, Sundt Unit
4, a dedicated 345-kV transmission line from Springerville Unit 2 to TEP's
retail service area (the Express Line), and a portion of TEP's local
transmission and distribution system in the Tucson metropolitan area. As of
December 31, 2004, TEP had approximately $584 million of tax-exempt local
furnishing bonds outstanding. Approximately $331 million in principal amount of
such bonds financed Springerville Unit 2 and the Express Line. In addition,
approximately $53 million of remaining lease debt related to the Sundt Unit 4
lease obligation was issued as tax-exempt local furnishing bonds.
K-46
Various events might cause TEP to have to redeem or defease some or all of
these bonds:
o formation of an RTO or ISO;
o asset divestiture;
o changes in tax laws; or
o changes in system operations.
TEP believes that its qualification as a local furnishing system should not
be lost so long as (1) the RTO or ISO would not change the operation of the
Express Line or the transmission facilities within TEP's local service area, (2)
the RTO or ISO allows pricing of transmission service such that the benefits of
tax-exempt financing continue to accrue to retail customers, and (3) energy
produced by Springerville Unit 2 and by TEP's local generating units continues
to be consumed in TEP's local service area. However, there is no assurance that
such qualification can be maintained. Any redemption or defeasance of these
bonds, subsequent to the debt retirements contemplated in TEP's planned
recapitalization, would likely require the issuance and sale of higher cost
taxable debt securities in the same or a greater amount.
Mortgage Indentures
-------------------
TEP's first mortgage indenture and second mortgage indenture create liens
on and security interests in most of TEP's utility plant assets. Springerville
Unit 2, which is owned by San Carlos, is not subject to these liens and security
interests. TEP's mortgage indentures allow TEP to issue additional mortgage
bonds on the basis of: (1) a percentage of net utility property additions and/or
(2) the principal amount of retired mortgage bonds. The amount of bonds that TEP
may issue is also subject to a net earnings test under each mortgage indenture.
TEP's Credit Agreement contains limits on the amount of First and Second
Mortgage Bonds that may be outstanding. The Credit Agreement allows no more than
$222 million of First Mortgage Bonds to be outstanding, and no more than a total
of $650 million in First and Second Mortgage Bonds to be outstanding. At
December 31, 2004, TEP had $191 million of First Mortgage Bonds and a total of
$592 million in First and Second Mortgage Bonds outstanding. Although the first
and second mortgage indentures would allow TEP to issue additional bonds based
on property additions and/or retired bond credits, the limits imposed by the
Credit Agreement are more restrictive and are currently the governing
limitations.
TEP also has the ability to release property from the liens of the mortgage
indentures on the basis of net property additions and/or retired bond credits.
TEP's Credit Agreement that was in effect in 2003 limited the amount of property
that could be released from the second mortgage indenture to $25 million. As a
result, TEP deposited $17 million in cash with the second mortgage trustee in
the fourth quarter of 2003 in conjunction with the release of $42 million in
property from its mortgage indentures related to the Springerville Unit 3
transaction. The $17 million deposit was refunded to TEP during 2004. This
limitation was removed when TEP refinanced its Credit Agreement in March 2004.
CONTRACTUAL OBLIGATIONS
The following charts display TEP's contractual obligations as of December
31, 2004 by maturity and by type of obligation.
- --------------------------------------------------------------------------------------------------------------------------
TEP'S CONTRACTUAL OBLIGATIONS
- MILLIONS OF DOLLARS -
- --------------------------------------------------------------------------------------------------------------------------
2011
Payment Due in Years and
Ending December 31, 2005 2006 2007 2008 2009 2010 after Total
- --------------------------------------------------------------------------------------------------------------------
Long-Term Debt:
Principal $ 2 $21 $ 1 $ 167 $ 329 $ - $ 579 $ 1,099
Interest 66 67 66 62 54 56 830 1,201
Capital Lease Obligations:
Springerville Unit 1 85 85 86 85 34 57 430 862
Springerville Coal Handling 17 22 24 18 15 17 98 211
Sundt Unit 4 11 10 12 12 13 13 - 71
Springerville Common 6 6 6 6 6 7 159 196
Rail Car Lease 1 - - - - - - 1
K-47
Operating Leases 1 1 1 1 1 1 - 6
Purchase Obligations:
Coal and Rail Transportation 89 87 79 79 79 79 278 770
Purchase Power 17 4 - - - - - 21
Gas 2 - - - - - - 2
Other Long-Term Liabilities:
Pension & Other Post
-Retirement Obligations 9 4 4 5 6 6 171 205
- --------------------------------------------------------------------------------------------------------------------
Total Contractual Cash Obligations $ 306 $ 307 $ 279 $ 435 $ 537 $ 236 $2,545 $ 4,645
====================================================================================================================
See UniSource Energy Consolidated, Liquidity and Capital Resources,
Contractual Obligations, above, for a description of these obligations.
We have no other commercial commitments to report.
We have reviewed our contractual obligations and provide the following
additional information:
o TEP's Credit Agreement contains pricing for its Revolving Credit
Facility based on TEP's leverage ratio. A change in TEP's leverage
ratio can cause an increase or decrease in the amount of interest TEP
pays on its borrowings.
o TEP's Credit Agreement contains certain financial and other
restrictive covenants, including interest coverage, leverage and net
worth tests. Failure to comply with these covenants would entitle the
lenders to accelerate the maturity of all amounts outstanding. At
December 31, 2004, TEP was in compliance with these covenants. See TEP
Credit Agreement, above.
o TEP conducts its wholesale trading activities under the Western System
Power Pool Agreement (WSPP) which contains provisions whereby TEP may
be required to post margin collateral due to a change in credit rating
or changes in contract values. As of December 31, 2004, TEP has not
been required to post such collateral.
DIVIDENDS ON COMMON STOCK
TEP declared and paid dividends of $32 million in 2004, $80 million in 2003
and $35 million in 2002. UniSource Energy is a primary holder of TEP's common
stock.
TEP can pay dividends if it maintains compliance with the TEP Credit
Agreement and certain financial covenants, including a covenant that requires
TEP to maintain a minimum level of net worth. As of December 31, 2004, the
required minimum net worth was $352 million. TEP's actual net worth at December
31, 2004 was $415 million. As of December 31, 2004, TEP was in compliance with
the terms of the Credit Agreement. See Financing Activities - TEP Credit
Agreement, above.
The ACC Holding Company Order stated that TEP may not pay dividends to
UniSource Energy in excess of 75% of its earnings until TEP's common equity
equals 37.5% of total capitalization (excluding capital lease obligations). The
Citizens Settlement Agreement, as approved by the ACC, modified this dividend
limitation so that it will remain in place until TEP's common equity equals 40%
of total capitalization (excluding capital lease obligations). As of December
31, 2004, TEP's common equity (as determined by the ACC for the purpose of this
limitation) equaled 27% of total capitalization (excluding capital lease
obligations).
In the first half of 2005, TEP expects to increase its common equity to 40%
of total capitalization (excluding capital lease obligations). It is anticipated
that an equity investment from UniSource Energy, together with the proceeds
realized through the $95 million inter-company note repayment, will be used by
TEP to retire or repurchase up to $225 million of its outstanding debt
obligations.
In addition to these limitations, the Federal Power Act states that
dividends shall not be paid out of funds properly included in capital accounts.
Although the terms of the Federal Power Act are unclear, we believe that there
is a reasonable basis to pay dividends from current year earnings. Therefore,
TEP declared its 2004, 2003 and 2002 dividends from its current year earnings
since TEP had an accumulated deficit, rather than positive retained earnings.
K-48
UNS GAS
RESULTS OF OPERATIONS
- ---------------------
UniSource Energy formed two operating companies, UNS Gas and UNS Electric,
to acquire the Arizona electric and gas assets from Citizens, as well as an
intermediate holding company, UES, to hold the common stock of UNS Gas and UNS
Electric. Results of operations in 2003 for UNS Electric and UNS Gas cover the
period from August 11, 2003, the date the assets were acquired from Citizens, to
December 31, 2003.
In its first full year of operations, UNS Gas' net income for 2004 was
approximately $6 million. We expect operations at UNS Gas to vary with the
seasons, with peak energy usage occurring in the winter months.
As of December 31, 2004, UNS Gas had approximately 133,400 retail
customers, a 5% increase from last year. The table below shows UNS Gas' therm
sales and revenues for 2004 and 2003. Results in 2003 are for the period August
11 to December 31.
Sales Revenue
2004 2003* 2004 2003*
- --------------------------------------------------------------------------------
- Millions of Therms - - Millions of Dollars -
RETAIL THERM SALES:
Residential 71 25 $ 76 $ 25
Commercial 29 12 27 11
Industrial 3 1 2 1
Public Authorities 7 3 6 2
- --------------------------------------------------------------------------------
TOTAL RETAIL THERM SALES 110 41 111 39
Transport - - 3 1
Negotiated Sales Program (NSP) 21 13 12 7
- --------------------------------------------------------------------------------
TOTAL THERM SALES 131 54 $ 126 $ 47
================================================================================
*For the period August 11 to December 31, 2003
Through a Negotiated Sales Program (NSP) approved by the ACC, UNS Gas
supplies natural gas to some of its large transportation customers.
Approximately one half of the margin earned on these NSP sales is retained by
UNS Gas, while the remainder benefits retail customers through a credit to the
Purchased Gas Adjustor (PGA) mechanism which reduces the gas commodity price.
See Factors Affecting Results of Operations, Rates and Regulation, Purchased Gas
Adjustor, below.
The table below provides summary financial information for UNS Gas.
2004 2003*
-------------------------------------------------------------------
- Millions of Dollars -
Gas Revenues $ 127 $46
Other Revenues 2 1
-----------------------------------------------------------------
Total Operating Revenues 129 47
Purchased Energy Expense 82 31
-----------------------------------------------------------------
Utility Gross Margin 47 16
-----------------------------------------------------------------
Other Operations and Maintenance Expense 23 8
Depreciation and Amortization 5 2
Taxes other than Income Taxes 3 2
-----------------------------------------------------------------
Total Other Operating Expenses 31 12
-----------------------------------------------------------------
Operating Income 16 4
-----------------------------------------------------------------
Total Interest Expense 6 2
Income Tax Expense 4 1
-----------------------------------------------------------------
NET INCOME $ 6 $ 1
=================================================================
*For the period August 11 to December 31, 2003
K-49
FACTORS AFFECTING RESULTS OF OPERATIONS
- ---------------------------------------
RATES AND REGULATION
ACC ORDER ON CITIZENS' ASSET ACQUISITION
On July 3, 2003, the ACC issued an order approving the acquisition of
Citizens' Arizona gas assets. Concurrent with the closing of the acquisition,
retail rate increases for customers of UNS Gas went into effect on August 11,
2003. Key provisions of the order include:
o 20.9% overall increase in retail rates through a base rate increase.
o Restricts the filing of a general rate case until August 2006 and any
resulting rate increase shall not become effective prior to August 1,
2007.
o Limits dividends payable by UNS Gas to UniSource Energy to 75% of
earnings until the ratio of common equity to total capitalization
reaches 40%.
ENERGY COST ADJUSTMENT MECHANISMS
UNS Gas' retail rates include a PGA mechanism intended to address the
volatility of natural gas prices and allows UNS Gas to recover its costs through
a price adjustor. The PGA charge may be changed monthly based on an ACC approved
mechanism that compares the twelve-month rolling average gas cost to the base
cost of gas, subject to limitations on how much the price per therm may change
in a twelve month period. The difference between the actual cost of UNS Gas' gas
supplies and transportation contracts and that currently allowed by the ACC are
deferred and recovered or repaid through the PGA mechanism. When under or over
recovery trigger points are met, UNS Gas may request a PGA surcharge or
surcredit with the goal of collecting or returning the amount deferred from or
to customers over a twelve month period.
In January 2005, UNS Gas requested the ACC approve a PGA surcharge of $0.06
per therm beginning April 1, 2005 and removed one year later, to recover its
excess gas purchase costs. On March 3, 2005, the ACC staff in its proposed
order, recommended implementation of a $0.05 per therm surcharge beginning April
1, 2005 to recover the uncollected PGA balance. The previous PGA surcharge of
$0.1155 per therm took effect October 1, 2003 and ended November 1, 2004.
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
UNS Gas' capital requirements consist primarily of capital expenditures. In
2004, capital expenditures were approximately $19 million. During 2005, UNS Gas
expects to generate sufficient internal cash flows to fund its operating
activities and a portion of its construction expenditures. Remaining cash needed
for construction expenditures is expected to be obtained through a combination
of additional equity investments from UniSource Energy and borrowings under a
revolving credit facility that UES expects to establish.
In January 2005, UNS Gas established a short-term inter-company promissory
note to UniSource Energy, by which it may borrow up to $10 million for general
corporate purposes. This note bears an interest rate of LIBOR plus 2.50% and
expires January 16, 2006.
On March 10, 2005, UniSource Energy contributed an additional $6 million in
equity to UNS Gas. On March 10, 2005, UNS Gas repaid the $6 million outstanding
on this note from the proceeds of the $6 million equity contribution described
above.
The table below provides summary information for operating cash flow and
capital expenditures for 2004 and 2003.
2004 2003*
- -----------------------------------------------------------------------
-Millions of Dollars-
Net Cash Flows - Operating Activities $ 21 $ 5
Capital Expenditures 19 9
- -----------------------------------------------------------------------
*For the period August 11 to December 31, 2003
K-50
Forecasted capital expenditures for UNS Gas are as follows:
2005 2006 2007 2008 2009
- --------------------------------------------------------------------------------
- Millions of Dollars -
UNS Gas $ 23 $ 20 $ 18 $ 19 $ 21
- --------------------------------------------------------------------------------
Senior Unsecured Notes
----------------------
On August 11, 2003, UNS Gas issued a total of $100 million of aggregate
principal amount of senior unsecured notes in a private placement consisting of
$50 million of 6.23% Notes due in 2011 and $50 million of 6.23% Notes due in
2015. Proceeds from the note issuance were paid to Citizens to purchase the
Arizona gas system assets. The notes are guaranteed by UES.
The note purchase agreements for UNS Gas 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
agreement for UNS Gas, 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 and UNS Gas at December 31, 2004.
COMPANY REQUIRED NET WORTH ACTUAL NET WORTH
- --------------------------------------------------------------------------------
- Millions of Dollars -
UES $ 50 $ 100
UNS Gas 43 59
- --------------------------------------------------------------------------------
The incurrence of indebtedness covenant requires UNS Gas to meet certain
tests before additional indebtedness may be incurred. These tests include:
o A ratio of Consolidated Long-Term Debt to Consolidated Total
Capitalization of no greater than 0.65 to 1.00.
o An Interest Coverage Ratio (a measure of cash flow to cover interest
expense) of at least 2.50 to 1.00.
However, UNS Gas may, without meeting these tests, refinance indebtedness
and incur short-term debt in an amount not to exceed $7 million. UNS Gas may not
declare or make distributions or dividends (restricted payments) on its common
stock unless (a) immediately after giving effect to such action no default or
event of default would exist under its note purchase agreement and (b)
immediately after giving effect to such action, it would be permitted to incur
an additional dollar of indebtedness under the debt incurrence test. As of
December 31, 2004, UNS Gas was in compliance with the terms of its note purchase
agreement.
The senior unsecured notes may be accelerated upon the occurrence and
continuance of an event of default under the note purchase agreement. Events of
default under the note purchase agreement include failure to make payments
required thereunder, certain events of bankruptcy or commencement of similar
liquidation or reorganization proceedings or a change of control of UES or UNS
Gas. In addition, an event of default may occur if UNS Gas, UES or UNS Electric
defaults on any payments required in respect of certain indebtedness that is
outstanding in an aggregate principal amount of at least $4 million or if any
such indebtedness becomes due or capable of being called for payment prior to
its scheduled payment date or if there is a default in the performance or
compliance with the other terms of such indebtedness and, as a result of such
default, such indebtedness has become, or has been declared, due and payable,
prior to its scheduled payment date.
CONTRACTUAL OBLIGATIONS
UNS GAS SUPPLY CONTRACTS
UNS Gas has a natural gas supply and management agreement with BP Energy
Company (BP). Under the contract, BP manages UNS Gas' existing supply and
transportation contracts and its incremental requirements. The initial term of
the agreement extends through August 31, 2005. The term of the agreement is
automatically extended one year on an annual basis unless either party provides
180 days notice of its intent to terminate. Prices for incremental gas supplied
by BP will vary based upon the period during which the gas is delivered.
K-51
UNS Gas hedges its gas supply prices by entering into fixed price forward
contracts at various times during the year to provide more stable prices to its
customers. These purchases are made up to three years in advance with the goal
of hedging at least 45% and not more than 80% of the expected monthly gas
consumption with fixed prices prior to entering into the month. UNS Gas hedged
approximately 60% of its expected monthly consumption for the 2004/2005 winter
season (November through March). Additionally, UNS Gas has approximately 50% of
its expected gas consumption hedged for April through July of 2005, and 35%
hedged for the period August 2005 through July of 2006.
UNS Gas has firm transportation agreements with El Paso Natural Gas (EPNG)
and Transwestern Pipeline Company (Transwestern) with combined capacity
sufficient to meet its load requirements.
In July 2003, FERC required the conversion of UNS Gas' full requirements
status under the EPNG agreement to contract demand starting on September 1,
2003. UNS Gas now has specific volume limits in each month and specific receipt
point rights from the available supply basins (San Juan and Permian). The
average daily capacity rights of UNS Gas after conversion to contract demand is
approximately 870,000 therms per day, with an average of 1,200,000 therms per
day in the winter season (November through March). These changes have also
reduced the amount of less expensive San Juan gas available to UNS Gas. The
impact, however, is not expected to be material. The annual cost of the EPNG
capacity after conversion to contract demand did not change. These costs will be
the same through 2005 (pending a 2006 EPNG rate case after which the rates are
expected to increase) as under UNS Gas' existing full requirements contract.
This contract expires in August 2011.
UNS Gas has capacity rights of 250,000 therms per day on the San Juan
Lateral and Mainline of the Transwestern pipeline. The Transwestern pipeline
principally delivers gas to the portion of UNS Gas' distribution system serving
customers in Flagstaff and Kingman, Arizona, and also delivers gas to UNS Gas'
facilities serving the Griffith Power Plant in Mohave County. This contract
expires in January 2007.
The aggregate annual minimum transportation charges are expected to be
approximately $4 million and $3 million for the EPNG and Transwestern contracts,
respectively. These costs are passed through to our customers via the Purchased
Gas Adjustor mechanism. See UniSource Energy Services, Factors Affecting Results
of Operations, Rates and Regulations, Energy Cost Adjustment Mechanisms, above.
DIVIDENDS ON COMMON STOCK
The Citizens Settlement Agreement, as approved by the ACC, limits dividends
payable by UNS Gas to 75% of earnings until the ratio of common equity to total
capitalization reaches 40%. At December 31, 2004, the ratio of common equity to
total capitalization for UNS Gas was 37%.
An equity investment of $6 million from UniSource Energy on March 10, 2005
increased UNS Gas' ratio of common equity to total capitalization to 40%.
The note purchase agreements for UNS Gas contain restrictive covenants
including restrictions on dividends. According to the note purchase agreements
UNS Gas may not declare or make distributions or dividends (restricted payments)
on its common stock unless, (a) immediately after giving effect to such action
no default or event of default would exist under its note purchase agreement and
(b) immediately after giving effect to such action, it would be permitted to
incur an additional dollar of indebtedness under the debt incurrence test. It is
unlikely, however, that UNS Gas will pay dividends in the next five years due to
expected cash requirements for capital expenditures.
UNS ELECTRIC
RESULTS OF OPERATIONS
- ---------------------
In its first full year of operations, UNS Electric's net income for 2004
was approximately $4 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.
As of December 31, 2004, UNS Electric had approximately 85,500 retail
customers, a 5% increase from last year. The table below shows UNS Electric's
kWh sales and revenues for 2004 and 2003. Results in 2003 are for the period
August 11 to December 31.
K-52
SALES REVENUE
2004 2003* 2004 2003*
- --------------------------------------------------------------------------------
- Millions of kWh - - Millions of Dollars -
ELECTRIC RETAIL SALES:
Residential 692 302 $ 70 $ 30
Commercial 574 153 58 16
Industrial 194 59 14 4
Other 3 47 1 5
- ------------------------------------------------------------------------------
TOTAL ELECTRIC RETAIL SALES 1,463 561 $143 $ 55
==============================================================================
*For the period August 11 to December 31, 2003
The table below provides summary financial information for UNS Electric.
2004 2003*
- ---------------------------------------------------------------------
-Millions of Dollars-
Electric Revenues $ 143 $ 55
Other Revenues 1 1
- ---------------------------------------------------------------------
Total Operating Revenues 144 56
Purchased Energy Expense 96 39
- ---------------------------------------------------------------------
Utility Gross Margin 48 17
- ---------------------------------------------------------------------
Other Operations and Maintenance Expense 24 6
Depreciation and Amortization 9 3
Taxes other than Income Taxes 3 3
- ---------------------------------------------------------------------
Total Other Operating Expenses 36 12
- ---------------------------------------------------------------------
Operating Income 12 5
- ---------------------------------------------------------------------
Total Interest Expense 5 2
Income Tax Expense 3 1
- ---------------------------------------------------------------------
NET INCOME $ 4 $ 2
=====================================================================
*For the period August 11 to December 31, 2003
FACTORS AFFECTING RESULTS OF OPERATONS
--------------------------------------
COMPETITION
As required by the ACC order approving UniSource Energy's acquisition of
the Citizens' Arizona gas and electric assets, on November 3, 2003, UNS Electric
filed with the ACC a plan to open its service territories to retail competition
by December 31, 2003. The plan addresses all aspects of implementation. It
includes UNS Electric's unbundled distribution tariffs for both standard offer
customers and customers that choose competitive retail access, as well as Direct
Access and Settlement Fee schedules. UNS Electric direct access rates for both
transmission and ancillary services will be based upon its FERC Open Access
Transmission Tariff. The plan is subject to review and approval by the ACC. As a
result of the court decisions concerning the ACC's Retail Electric Competition
Rules, we are unable to predict when and how the ACC will address this plan. See
Tucson Electric Power Company, Factors Affecting Results of Operations,
Competition, above for information regarding the recent Arizona Court of Appeals
decision.
RATES AND REGULATION
ACC ORDER ON CITIZENS' ASSET ACQUISITION
On July 3, 2003, the ACC issued an order approving the acquisition of
Citizens' Arizona electric assets. Concurrent with the closing of the
acquisition, retail rate increases for customers of UNS Electric went into
effect on August 11, 2003. Key provisions of the order include:
o 22% overall increase in retail rates through its Purchased Power Fuel
Adjustor Clause (PPFAC).
o UNS Electric must file a plan with the ACC to open its service
territories to retail competition by no later than December 31, 2003
(which was filed by UNS Electric on November 3, 2003).
K-53
o Restricts the filing of a general rate case until August 2006 and any
resulting rate increase shall not become effective prior to August 1,
2007.
o Limits dividends payable by UNS Electric to UniSource Energy to 75% of
earnings until the ratio of common equity to total capitalization
reaches 40%.
o Requires UNS Electric to enter into negotiations with Pinnacle West
Capital Corporation (PWCC) to seek to reduce the cost of its purchased
power contract with PWCC.
ENERGY COST ADJUSTMENT MECHANISMS
UNS Electric's retail rates include a PPFAC, which allows for a separate
surcharge or surcredit to the base rate for delivered purchased power to collect
or return under or over recovery of costs. As part of the July 3, 2003 ACC
Order, a new PPFAC surcharge of $0.01825 per kWh was approved to fully recover
the cost of the current full-requirements power supply agreement with PWCC. UNS
Electric is required to enter into negotiations with PWCC to potentially reduce
the cost of this purchased power contract; 90% of any savings from the
negotiations is to be passed on to UNS Electric rate payers.
LIQUIDITY AND CAPITAL RESOURCES
-------------------------------
UNS Electric's capital requirements consist primarily of capital
expenditures. In 2004, capital expenditures were approximately $19 million.
During 2005, UNS Electric expects to generate sufficient internal cash flows to
fund its operating activities and a portion of its construction expenditures.
Remaining cash needed for construction expenditures is expected to be obtained
through a combination of additional equity investments from UniSource Energy and
borrowings under a revolving credit facility that UES expects to establish.
On March 10, 2005, UniSource Energy contributed an additional $4 million in
equity to UNS Electric.
The table below provides summary information for operating cash flow and
capital expenditures for 2004 and 2003.
2004 2003*
- -----------------------------------------------------------------------
-Millions of Dollars-
Net Cash Flows - Operating Activities $ 19 $ 8
Capital Expenditures 19 5
- -----------------------------------------------------------------------
*For the period August 11 to December 31, 2003
Forecasted capital expenditures for UNS Electric are as follows:
2005 2006 2007 2008 2009
- Millions of Dollars -
- --------------------------------------------------------------------------------
UNS Electric $ 26 $ 30 $ 26 $ 26 $ 27
- --------------------------------------------------------------------------------
Senior Unsecured Notes
----------------------
On August 11, 2003, UNS Electric issued $60 million of aggregate principal
amount of 7.61% senior unsecured notes due in 2008 in a private placement.
Proceeds from the note issuance were paid to Citizens to purchase the Arizona
electric system assets. The notes are guaranteed by UES.
The note purchase agreements for 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 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 and UNS Electric at December 31, 2004.
COMPANY REQUIRED NET WORTH ACTUAL NET WORTH
- ---------------------------------------------------------------------
- Millions of Dollars -
UES $ 50 $ 100
UNS Electric 26 41
- ---------------------------------------------------------------------
The incurrence of indebtedness covenant requires UNS Electric to meet
certain tests before additional indebtedness may be incurred. These tests
include:
K-54
o A ratio of Consolidated Long-Term Debt to Consolidated Total
Capitalization of no greater than 0.65 to 1.00.
o An Interest Coverage Ratio (a measure of cash flow to cover interest
expense) of at least 2.50 to 1.00.
However, UNS Electric may, without meeting these tests, refinance
indebtedness and incur short-term debt in an amount not to exceed $5 million.
UNS Electric may not declare or make distributions or dividends (restricted
payments) on its common stock unless (a) immediately after giving effect to such
action no default or event of default would exist under its note purchase
agreement and (b) immediately after giving effect to such action, it would be
permitted to incur an additional dollar of indebtedness under the debt
incurrence test. As of December 31, 2004, UNS Electric was in compliance with
the terms of the note purchase agreement.
The senior unsecured notes may be accelerated upon the occurrence and
continuance of an event of default under the note purchase agreement. Events of
default under the note purchase agreement include failure to make payments
required thereunder, certain events of bankruptcy or commencement of similar
liquidation or reorganization proceedings or a change of control of UES or UNS
Electric. In addition, an event of default may occur if UNS Electric, UES or UNS
Gas defaults on any payments required in respect of certain indebtedness that is
outstanding in an aggregate principal amount of at least $4 million or if any
such indebtedness becomes due or capable of being called for payment prior to
its scheduled payment date or if there is a default in the performance or
compliance with the other terms of such indebtedness and, as a result of such
default, such indebtedness has become, or has been declared, due and payable,
prior to its scheduled payment date.
CONTRACTUAL OBLIGATIONS
UNS ELECTRIC POWER SUPPLY AND TRANSMISSION CONTRACTS
UNS Electric has a full requirements power supply agreement with PWCC. The
agreement expires May 31, 2008. The agreement obligates PWCC to supply all of
UNS Electric's power requirements at a fixed price per MWh. Payments under the
contract are usage based, with no fixed customer or demand charges. UNS Electric
is currently evaluating potential replacement energy resources when its supply
contract ends with PWCC in 2008.
UNS Electric imports the power it purchases over the Western Area Power
Administration's (WAPA) transmission lines. UNS Electric's transmission capacity
agreements with WAPA provide for annual rate adjustments and expire in February
2008 and June 2011. The contract that expires in 2008 also contains a capacity
adjustment clause. Under the terms of the agreements, UNS Electric's aggregated
minimum fixed transmission charges are expected to be $1 million in 2005 through
2011. UNS Electric made payments under these contracts of $6 million in 2004 and
$2 million in 2003.
DIVIDENDS ON COMMON STOCK
The Citizens Settlement Agreement, as approved by the ACC, limits dividends
payable by UNS Electric to 75% of earnings until the ratio of common equity to
total capitalization reaches 40%. At December 31, 2004, the ratio of common
equity to total capitalization for UNS Electric was 40%.
A $4 million equity investment from UniSource Energy on March 10, 2005
increased UNS Electric's ratio of common equity to total capitalization to more
than 40%.
The note purchase agreement for UNS Electric contains restrictive covenants
including restrictions on dividends. According to the note purchase agreements
UNS Electric may not declare or make distributions or dividends (restricted
payments) on its common stock unless, (a) immediately after giving effect to
such action no default or event of default would exist under its note purchase
agreement and (b) immediately after giving effect to such action, it would be
permitted to incur an additional dollar of indebtedness under the debt
incurrence test.
GLOBAL SOLAR ENERGY, INC.
RESULTS OF OPERATIONS
- ---------------------
UniSource Energy 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.
Millennium made no contributions to Global Solar during 2004. However, UniSource
Energy provided $7 million to Global Solar under a tax sharing agreement.
K-55
Millennium has been authorized to fund up to an additional $5 million for
capital expenditures and operations at Global Solar.
The table below provides a breakdown of the net losses recorded by Global
Solar for the last three years.
2004 2003 2002
- ----------------------------------------------------------------------------------------------------------
- Millions of Dollars -
Global Solar
Research & Development Contract Revenues from Third Parties $ 1 $ 1 $ 1
Other Revenues 8 9 7
Research & Development Contract Expenses & Losses (4) (5) (4)
Research & Development - Internal Development Expenses - (1) (2)
Depreciation & Amortization Expense (3) (3) (3)
Administrative & Other Costs (11) (13) (14)
Income Tax Benefits 4 5 1
- ----------------------------------------------------------------------------------------------------------
Total Global Solar Net Loss $ (5) $ (7) $ (14)
==========================================================================================================
GLOBAL SOLAR COMMITMENTS
It is our intention for UniSource Energy to cease additional funding of
Global Solar. To that end, Millennium plans to seek additional investors for
Global Solar, or sell all or part of its interest, or a combination of both, to
preserve the value of Global Solar. We anticipate that any operating and capital
funding required to maintain Global Solar in the interim will be provided only
out of existing Millennium cash or cash returns from Millennium investments. We
believe such cash and returns will be adequate for that purpose and to fund
Millennium's remaining commitments to Global Solar. Millennium has been
authorized to fund up to an additional $5 million for capital expenditures and
operations at Global Solar. Global Solar has $1 million in commitments to incur
future expenses related to government contracts.
OTHER
RESULTS OF OPERATIONS
- ---------------------
The Other segment consists of: UniSource Energy parent company expenses;
income and losses from other Millennium investments; and income and losses from
UED. UniSource Energy parent company expenses include: interest expense (net of
tax) on the note payable from UniSource Energy to TEP and costs in 2003
associated with the Citizens acquisition.
The table below summarizes the income and losses for the Other segment in
the last three years.
2004 2003 2002
- -----------------------------------------------------------------------------
- Millions of Dollars -
Other Millennium Investments $ 1 $ (9) $ (2)
UED (1) 7 1
UniSource Energy Parent Company (5) (9) (5)
- -----------------------------------------------------------------------------
Total Other $ (5) $ (11) $ (6)
=============================================================================
OTHER MILLENNIUM INVESTMENTS
Millennium accounts for its investments under the consolidation method and
the equity method. In some cases, Millennium is an investment's sole provider of
funding. When this is the case, Millennium recognizes 100% of an investment's
losses, because as sole provider of funds it bears all of the financial risk. To
the extent that an investment becomes profitable and Millennium has recognized
losses in excess of its percentage ownership, Millennium will recognize 100% of
an investment's net income until Millennium's recognized losses equal its
ownership percentage of losses.
Results from Other Millennium Investments in 2004 include after-tax gains
of $3 million from Haddington, $2 million from MicroSat and less than $1 million
from SES. The gains were partially offset by after-tax losses of $2 million from
K-56
IPS and less than $1 million each from MEG, Nations Energy and POWERTRUSION
International, Inc. (Powertrusion), a manufacturer of lightweight utility poles.
Results from Other Millennium Investments in 2003 include after-tax losses
of $2 million each from IPS and Powertrusion, $1 million from MicroSat, and less
than $1 million each from MEG, SES, Nations Energy and TruePricing, Inc.
(TruePricing).
Results from Other Millennium Investments in 2002 include after-tax losses
of $3 million from IPS, $2 million from Powertrusion and less than $1 million
each from TruePricing, MEG and SES. These losses were partially offset by income
tax benefits recorded by Advanced Energy Technologies, the holding company that
holds Millennium's investments in Global Solar and IPS.
CONSOLIDATED MILLENNIUM INVESTMENTS
Millennium funded $1.5 million in debt commitments to IPS during 2004, and
Dow Corning Enterprises, Inc. (DCEI) also funded its $1 million commitment.
Pursuant to the terms of 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 has been authorized to fund up to an additional
$3.3 million for capital and operations at IPS. Millennium and DCEI are
continuing to evaluate the ongoing viability of IPS. In the event the operations
of IPS are discontinued, Millennium would recognize an after-tax loss of less
than $1 million.
MEG is in the process of winding down its activities and will not engage in
any new activities after 2005. As of January 31, 2005, the fair value of MEG's
trading assets was $62 million and the fair value of MEG's trading liabilities
was $56 million.
Through subsidiaries, Nations Energy has a 32% interest in a 43 MW power
plant in Panama. Although Nations Energy still intends to sell its interest in
this plant, the $0.8 million book value of the investment was written off in
2004 because attempts to sell the asset to date have been unsuccessful.
EQUITY METHOD MILLENNIUM INVESTMENTS
In 2004, Haddington sold one of its investments and recognized the related
gain as income. Millennium's pre-tax share of the gain was $5 million and
Millennium received a $7 million distribution from Haddington related to the
sale. Haddington also wrote down another of its investments and recognized the
related loss. Millennium's pre-tax share of the loss was $2 million. Millennium
recorded its share of Haddington's income and loss during 2004, which includes
Haddington's gains and losses on investments.
Millennium's after-tax gains from MicroSat in 2004 resulted primarily from
the settlement of a cost share agreement under a government contract and an
overhead billing rate adjustment. Millennium made no contributions to MicroSat
during 2004 and has no further funding commitments to MicroSat. As sole funder,
Millennium recognizes 100% of MicroSat's net income/losses.
As technology developers, Global Solar, IPS and MicroSat face many
challenges, such as developing technologies that can be manufactured on an
economic scale, technological obsolescence, competition and possible reductions
in government spending to advance technological research and development
activities.
MILLENNIUM COMMITMENTS
It is our intention for UniSource Energy to cease making capital
contributions to Millennium. To that end, Millennium has eliminated its
investment in TruePricing and significantly reduced the holdings and activities
of MEG. Millennium is also in the process of selling its remaining interest in
Nations Energy. Millennium plans to seek additional investors for Global Solar
and IPS, or sell all or part of its interest in those entities, or a combination
of both, to preserve the value of the investments. We anticipate that any
operating and capital funding required to maintain Global Solar or IPS in the
interim will be provided only out of existing Millennium cash or cash returns
from Millennium investments. We believe such cash and returns will be adequate
for that purpose and to fund Millennium's remaining commitments. To date,
Millennium has been authorized to fund up to an additional $5 million for
capital expenditures and operations at Global Solar, and up to $3.3 million for
capital and operations at IPS. Millennium's remaining commitments for other
Millennium investments are $4 million to Haddington and $3 million to Valley
Ventures.
K-57
UNISOURCE ENERGY DEVELOPMENT
In June 2004, UED recognized an impairment loss on its note receivable from
an independent power producer. As UED's recovery of the note receivable from the
entity is subordinated to the rights of others, UED wrote off the entire $2
million balance due on the note at the time that Haddington, an investor in the
independent power producer, determined that its investment was impaired. In
2004, UED's net loss was $1 million.
UED recorded net income of $7 million in 2003 compared with $1 million in
2002. UED's income in 2003 primarily represents an $11 million pre-tax
development fee received at the financial closing of the Springerville Unit 3
Project.
UED's net income in 2002 represented rental income (less expenses) under an
operating lease of the 20 MW North Loop turbine to TEP. The rental income was
eliminated from UniSource Energy's consolidated after-tax earnings as an
inter-company transaction. TEP purchased the turbine from UED in September 2002.
On October 21, 2003, Tri-State completed financing of Unit 3 and began
construction. UED received reimbursement of its development costs totaling $29
million, as well as an $11 million development fee. On October 24, 2003,
UniSource Energy used the proceeds to repay a $35 million short-term bridge
loan.
TEP will manage the development of Unit 3. Upon the completion of
construction in the third quarter of 2006, TEP expects to receive annual pre-tax
benefits of approximately $15 million in the form of cost savings, rental
payments, transmission revenues, and other fees. TEP will also benefit from
upgraded emissions controls for Units 1 and 2, totaling approximately $90
million, which will be paid for by the Unit 3 project.
UED has no significant current operations.
CRITICAL ACCOUNTING ESTIMATES
- -----------------------------
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 Estimates 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 Estimates
below. Other significant accounting policies and recently issued accounting
standards are discussed in Note 1 of Notes to Consolidated Financial Statements
- - Nature of Operations and Summary of Significant Accounting Estimates.
ACCOUNTING FOR RATE REGULATION
TEP, UNS Gas and UNS Electric generally use the same accounting policies
and practices used by unregulated companies for financial reporting under GAAP.
However, sometimes these principles, such as the Financial Accounting Standards
Board's (FASB) Statement of Financial Accounting Standards No. 71, Accounting
for the Effects of Certain Types of Regulation (FAS 71), require special
accounting treatment for regulated companies to show the effect of regulation.
For example, in setting TEP, UNS Gas and UNS Electric's retail rates, the ACC
may not allow TEP, UNS Gas or UNS Electric to currently charge their customers
to recover certain expenses, but instead may require that these expenses be
charged to customers in the future. In this situation, FAS 71 requires that TEP,
UNS Gas and UNS Electric defer these items and show them as regulatory assets on
the balance sheet until TEP, UNS Gas and UNS Electric are allowed to charge
their customers. TEP, UNS Gas and UNS Electric 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.
K-58
TEP
In November 1999, upon approval by the ACC of the TEP Settlement Agreement
relating to recovery of TEP's transition costs and standard retail rates, TEP
discontinued application of FAS 71 to its generation operations. TEP's
transmission and distribution regulatory assets, net of regulatory liabilities,
totaled $225 million at December 31, 2004, $23 million of which is not presently
included in the rate base and consequently is not earning a return on
investment.
TEP continues to apply FAS 71 to its regulated operations, which include
the transmission and distribution portions of its business. TEP regularly
assesses whether it can continue to apply FAS 71 to these operations. If TEP
stopped applying FAS 71 to its remaining regulated operations, it would write
off the related balances of its regulatory assets as an expense and its
regulatory liabilities as income on its income statement. Based on the
regulatory asset balances, net of regulatory liabilities, at December 31, 2004,
if TEP had stopped applying FAS 71 to its remaining regulated operations, it
would have recorded an extraordinary after-tax loss of approximately $136
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.
UNS GAS AND UNS ELECTRIC
UNS Gas and UNS Electric's regulatory liabilities, net of regulatory
assets, collectively totaled $4 million at December 31, 2004. UNS Gas and UNS
Electric's regulatory assets and liabilities are included in rate base and
consequently are earning a return on investment. If UNS Gas and UNS Electric
stopped applying FAS 71 to their regulated operations, they would write off the
related balances of regulatory assets as an expense and regulatory liabilities
as income on their income statements. Based on the balances of regulatory
liabilities and assets at December 31, 2004, if UNS Gas and UNS Electric had
stopped applying FAS 71 to their regulated operations, they would have
collectively recorded an extraordinary after-tax gain of $2 million. UNS Gas and
UNS Electric's cash flows would not be affected if they stopped applying FAS 71
unless a regulatory order limited their ability to recover the cost of their
regulatory assets.
ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS
FAS 143, issued by the FASB in June 2001, requires entities to record the
fair value of a liability for a legal obligation to retire an asset in the
period in which the liability is incurred. A legal obligation is a liability
that a party is required to settle as a result of an existing or enacted law,
statute, ordinance or contract. When the liability is initially recorded, the
entity should capitalize a cost by increasing the carrying amount of the related
long-lived asset. Over time, the liability is adjusted to its present value by
recognizing accretion expense as an operating expense in the income statement
each period, and the capitalized cost is depreciated over the useful life of the
related asset. Upon settlement of the liability, an entity either settles the
obligation for its recorded amount or incurs a gain or loss if the actual costs
differ from the recorded amount.
TEP
Prior to adopting FAS 143, costs for final removal of all owned generation
facilities were accrued as an additional component of depreciation expense.
Under FAS 143, only the costs to remove an asset with legally binding retirement
obligations will be accrued over time through accretion of the asset retirement
obligation and depreciation of the capitalized asset retirement cost.
TEP has identified legal obligations to retire generation plant assets
specified in land leases for its jointly-owned Navajo and Four Corners
Generating Stations. The land on which these stations reside is leased from the
Navajo Nation. The provisions of the leases require the lessees to remove the
facilities upon request of the Navajo Nation at the expiration of the leases.
TEP also has certain environmental obligations at the San Juan Generating
Station. TEP has estimated that its share of the cost to remove the Navajo and
Four Corners facilities and settle the San Juan environmental obligations will
be approximately $38 million at the date of retirement. No other legal
obligations to retire generation plant assets were identified. As of December
31, 2002, TEP had accrued $113 million for the final decommissioning of its
generating facilities. As discussed below, this amount was reversed for 2002 and
included as part of the cumulative effect of accounting change adjustment when
FAS 143 was adopted on January 1, 2003.
On November 12, 2004, TEP, Phelps Dodge Energy Services, LLC and PNM
Resources, Inc. each purchased from Duke Energy North America, LLC a one-third
interest in a limited liability company which owns the partially constructed
natural gas-fired Luna Energy Facility (Luna) in southern New Mexico. Luna is
designed as a 570-MW combined cycle plant and is expected to be operational by
the summer of 2006. See Item 1. - Future Generating Resources - TEP. The new
K-59
owners assumed asset retirement obligations to remove certain piping and
evaporation ponds and to restore the ground to its original condition. TEP has
estimated its share to settle the obligations will be approximately $2 million
at the date of retirement.
TEP has various transmission and distribution lines that operate under land
leases and rights of way that contain end dates and restorative clauses. TEP
operates its transmission and distribution lines as if they will be operated in
perpetuity and would continue to be used or sold without land remediation. As a
result, TEP is not recognizing the costs of final removal of the transmission
and distribution lines in the financial statements. As of December 31, 2004, TEP
had accrued $67 million for the net cost of removal for the interim retirements
from its transmission, distribution and general plant. As of December 31, 2003,
TEP had accrued $60 million for these removal costs. The amount is recorded 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). Adopting FAS 143 has resulted in a
reduction to current depreciation expense charged throughout the year as well
because asset retirement costs are no longer recorded as a component of
depreciation expense. For the year ended December 31, 2003 and succeeding years,
the annual reduction in depreciation expense is approximately $6 million.
Amounts recorded under FAS 143 are subject to various assumptions and
determinations, such as determining whether a legal obligation exists to remove
assets, estimating the fair value of the costs of removal, estimating when final
removal will occur, and the credit-adjusted risk-free interest rates to be used
to discount future liabilities. Changes that may arise over time with regard to
these assumptions and determinations will change amounts recorded in the future
as expense for asset retirement obligations.
If TEP retires any asset at the end of its useful life, without a legal
obligation to do so, it will record retirement costs at that time as incurred or
accrued. TEP does not believe that the adoption of FAS 143 will result in any
change in retail rates since all matters relating to the rate-making treatment
of TEP's generating assets have been determined pursuant to the TEP Settlement
Agreement.
UES
UES has various transmission and distribution lines that operate under land
leases and rights of way that contain end dates and restorative clauses. UES
operates its transmission and distribution lines as if they will be operated in
perpetuity and would continue to be used or sold without land remediation. As a
result, UES is not recognizing the cost of final removal of the transmission and
distribution lines in the financial statements. As of December 31, 2004, UES had
accrued $2 million and as of December 31, 2003, UES had accrued $0.6 million for
the net cost of removal for interim retirements from its transmission,
distribution and general plant. The amount is recorded as a regulatory
liability.
PENSION AND OTHER POST RETIREMENT 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 at December 31, 2004
using rates of 6.1% for its Salaried and Union Plans and 6.0% for its Excess
Benefit Plan. The discount rate used at December 31, 2003 was 6.25% for all
plans. TEP discounted its other postretirement plan obligations using a rate of
5.9% at December 31, 2004, compared with 5.5% at December 31, 2003. 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 whose future cash flows
match the timing and amount of expected future benefit payments.
K-60
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 2005 by approximately
$1 million. A similar increase in the discount rate would decrease the ABO by
approximately $5 million and the related plan expense for 2005 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 2005.
TEP calculates the market-related value of plan assets using the fair value
of plan assets on the measurement date. TEP assumed that its plans' assets would
generate a long-term rate of return of 8.5% at December 31, 2004 and 8.75% at
December 31, 2003. 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 2005.
TEP used an initial health care cost trend rate of 11.0% in valuing its
postretirement benefit obligation at December 31, 2004. This rate reflects both
market conditions and the plan's experience. 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 $4 million and the related plan expense by less than $1 million.
TEP recorded a minimum pension liability in Other Comprehensive Income of
approximately $20 million at December 31, 2004, compared with $3 million at
December 31, 2003. This increase resulted primarily from changes in actuarial
assumptions including revised retirements rates, updated mortality rates and a
reduction in the assumed discount rate.
Based on the above assumptions, TEP will record pension expense of
approximately $10 million and other postretirement benefit expense of $7 million
ratably throughout 2005. TEP will make required pension plan contributions of $6
million in 2005. 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 2005.
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 discounted its future pension plan obligations using a rate of 6.1% at
December 31, 2004 and 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 and
an offsetting Intangible Asset of less than $1 million at December 31, 2004 and
approximately $1 million at December 31, 2003. UES will record pension expense
of $1 million in 2005. UES will make a pension plan contribution of $1 million
in 2005.
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 plan is not funded. UES discounted its other
K-61
postretirement plan obligations using a rate of 5.9% at December 31, 2004,
compared with 5.5% at December 31, 2003. Postretirement medical benefit expenses
are insignificant to UES' operations.
ACCOUNTING FOR DERIVATIVE INSTRUMENTS, TRADING ACTIVITIES AND HEDGING
ACTIVITIES
A derivative financial instrument or other contract derives its value from
another investment or designated benchmark. TEP enters into forward contracts to
purchase or sell a specified amount of capacity or energy at a specified price
over a given period of time, typically for one month, three months, or one year,
within established limits to take advantage of favorable market opportunities.
In general, TEP enters into forward purchase contracts when market conditions
provide the opportunity to purchase energy for its load at prices that are below
the marginal cost of its supply resources or to supplement its own resources
(e.g., during plant outages and summer peaking periods). TEP enters into forward
sales contracts when it forecasts that it has excess supply and the market price
of energy exceeds its marginal cost. The majority of TEP's forward contracts are
considered to be normal purchases and sales and, therefore, are not required to
be marked to market. However, some of these forward contracts are considered to
be derivatives, which TEP marks to market by recording unrealized gains and
losses and adjusting the related assets and liabilities on a monthly basis to
reflect the market prices at the end of the month.
TEP 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. During 2004 and early 2005, 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 expire during the summer months through
2007, 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. As the gains and losses on these cash flow
hedges are realized, a reclassification adjustment is recorded in Other
Comprehensive Income for realized gains and losses that are included in Net
Income.
TEP manages the risk of counterparty default by performing financial credit
reviews, setting limits, monitoring exposures, requiring collateral when needed,
and using a standardized agreement which allows for the netting of current
period exposures to and from a single counterparty.
UNS Gas and UNS Electric do not currently have any contracts that are
required to be marked to market. UNS Gas does have a natural gas supply and
management agreement under which it purchases substantially all of its gas
requirements at market prices from BP Energy Company (BP). However, the contract
terms allow UNS Gas to lock in fixed prices on a portion of its gas purchases by
entering into fixed price forward contracts with BP at various times during the
year. This enables UNS Gas to provide more stable prices to its customers. These
purchases are made up to three years in advance with the goal of locking in
fixed prices on at least 45% and not more than 80% of the expected monthly gas
consumption prior to entering into the month. These forward contracts, as well
as the main gas supply contract, meet the definition of normal purchases and
therefore are not required to be marked to market.
MEG, a wholly-owned subsidiary of Millennium, enters into swap agreements,
options and forward contracts relating to Emissions Allowances and coal. MEG
marks its trading contracts to market by recording unrealized gains and losses
and adjusting the related assets and liabilities on a monthly basis to reflect
the market prices at the end of the month. In accordance with UniSource Energy's
intention to cease making capital contributions to Millennium, Millennium has
significantly reduced the holdings and activity of MEG. MEG is in the process of
winding down its activities and will not engage in any new activities after
2005.
The market prices used to determine fair values for TEP and MEG's
derivative instruments at December 31, 2004 are estimated based on various
factors including broker quotes, exchange prices, over the counter prices and
time value. For TEP's forward power contracts, a 10% decrease in market prices
would result in an increase in unrealized gains of less than $1 million, while a
10% increase in market prices would result in a decrease in unrealized gains of
less than $1 million. For TEP's gas swap agreements, a 10% decrease in market
prices would result in a $2 million decrease in unrealized gains reported in
Other Comprehensive Income, while a 10% increase in market prices would result
in a $2 million increase in unrealized gains reported in Other Comprehensive
Income. For MEG's remaining trading contracts, a 10% decrease in market prices
K-62
would result in a decrease in unrealized gains of less than $1 million, while a
10% increase in market prices would result in an increase in unrealized gains of
less than $1 million.
Because of the complexity of derivatives, the FASB established a
Derivatives Implementation Group (DIG). To date, the DIG has issued more than
100 interpretations to provide guidance in applying Statement of Financial
Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging
Activities (FAS 133). As the DIG or the FASB continues to issue interpretations,
TEP, UNS Gas and UNS Electric may change the conclusions they have reached and,
as a result, the accounting treatment and financial statement impact could
change in the future.
See Market Risks - Commodity Price Risk in Item 7A.
UNBILLED REVENUE - TEP AND UES
TEP's, UNS Gas's and UNS Electric's retail revenues include an estimate of
MWhs/therms delivered but unbilled at the end of each period. Unbilled revenues
are dependent upon a number of factors that require management's judgment
including estimates of retail sales and customer usage patterns. The unbilled
revenue is estimated by comparing the estimated MWhs/therms delivered to the
MWhs/therms billed to TEP, UNS Gas and UNS Electric retail customers. The excess
of estimated MWhs/therms delivered over MWhs/therms billed is then allocated to
the retail customer classes based on estimated usage by each customer class.
TEP, UNS Gas and UNS Electric then record revenue for each customer class based
on the various bill rates for each customer class. Due to the seasonal
fluctuations of TEP's actual load, the unbilled revenue amount increases during
the spring and summer months and decreases during the fall and winter months.
The unbilled revenue amount for UNS Gas sales increases during the fall and
winter months and decreases during the spring and summer months, whereas, the
unbilled revenue amount for UNS Electric sales increases during the spring and
summer months and decreases during the fall and winter 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.
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. For 2004,
depreciation expense related to generation assets was $35 million, and our
generation assets are currently depreciated over periods ranging from 23 to 70
years from the original in-service dates.
During the first quarter of 2004, TEP engaged an independent third party to
review the economic estimated useful lives of its owned generating assets in
Springerville, Arizona. TEP then hired a different independent third party to
perform a depreciation study for its generation assets, taking into
consideration the newly determined economic useful life for the Springerville
assets, and changes in generation plant life information used by the operators
and other participants of the joint power plants in which TEP participates. As a
result of these analyses, TEP lengthened the useful lives of various generation
assets for periods ranging from 11 to 22 years in July 2004. Consequently,
depreciation rates and the corresponding depreciation expense have been revised
prospectively to reflect the life extensions. The annual impact of these changes
in depreciation rates is a reduction in depreciation expense of $9 million. A
study is currently underway by the operating agent of the San Juan Generating
Station to determine whether San Juan's economic useful life has changed from
previous estimates. If the economic life of San Juan is extended by ten years,
TEP's annual depreciation expense would decrease by an additional $4 million.
DEFERRED TAX VALUATION - TEP AND MILLENNIUM
We record deferred tax liabilities for amounts that will increase income
taxes on future tax returns. We record deferred tax assets for amounts that
could be used to reduce income taxes on future tax returns. We record a
valuation allowance, or reserve, for the deferred tax asset amount that we may
not be able to use on future tax returns. We estimate the valuation allowance
based on our interpretation of the tax rules, prior tax audits, tax planning
strategies, scheduled reversal of deferred tax liabilities, and projected future
taxable income.
K-63
The valuation allowance of $8 million at December 31, 2004 and $7 million
at December 31, 2003, which reduces the Deferred Tax Asset balance, relates to
net operating loss and investment tax credit carryforward amounts. The increase
of $1 million reflects the expiration of unused investment tax credit.
Of the $8 million valuation allowance balance at December 31, 2004, $7
million relates to losses generated by the Millennium entities. In the future if
UniSource Energy and the Millennium entities determine that all or a portion of
the remaining amounts may be used on tax returns, then UniSource Energy and the
Millennium entities would reduce the valuation allowance and recognize a tax
benefit of up to $7 million. The main factor that could cause UniSource Energy
and the Millennium entities to recognize a tax benefit would be a change in
expected future taxable income. The remaining $1 million of valuation allowance
balance at December 31, 2004, relates to ITC carryforwards at TEP which may not
be utilized on tax returns prior to their expiration. If in the future UniSource
Energy and TEP determine that it is probable that TEP will not be able to use
all or a portion of additional investment tax credit carryforward amounts, then
UniSource Energy and TEP would record a valuation allowance and recognize tax
expense. The primary factor that could cause TEP to record a valuation allowance
would be a change in expected future taxable income.
As of December 31, 2004, UniSource Energy's deferred income tax assets
include $14 million related to unregulated investment losses of Millennium.
TEP's deferred income tax assets include $1 million related to unregulated
investment losses. These losses have not been reflected on UniSource Energy's
consolidated income tax returns. If UniSource Energy is unable to recognize such
losses through its consolidated income tax return in the foreseeable future,
UniSource Energy and TEP would be required to write off these deferred tax
assets. Millennium intends to restructure its ownership in one of these
investments, Infinite Power Solutions (IPS), in 2005. As a result of this
restructuring, UniSource Energy expects to liquidate IPS for tax purposes
resulting in a taxable loss that will be reflected on UniSource Energy's
consolidated income tax return. If this liquidation, or another action resulting
in the recognition of the loss for tax purposes, does not occur UniSource Energy
would be required to eliminate the deferred tax assets and recognize additional
tax expense of $6 million.
NEW ACCOUNTING PRONOUNCEMENTS
- -----------------------------
The FASB recently issued the following Statements of Financial Accounting
Standards (FAS) and FASB Interpretations (FIN):
o FAS 123(R), Share Based Payment, issued December 2004, requires all
share-based payments to employees, including grants of employee stock
options, to be recognized in the financial statements based on their
fair values. FAS 123(R) is effective for financial periods beginning
July 1, 2005. However, management early adopted FAS 123(R) effective
January 1, 2005. The adoption of FAS 123(R) did not have a significant
impact on our financial statements because stock options issued under
UniSource Energy's Omnibus Plan vested upon the shareholder vote to
approve the proposed acquisition of UniSource Energy by Saguaro. In
addition, the Omnibus Plan expired in February 2004, and no new
options can be issued. See Note 2 and Note 17 of Notes to Consolidated
Financial Statements.
o FAS 153, Exchanges of Nonmonetary Assets, issued December 2004,
requires nonmonetary exchanges be accounted for at fair value,
recognizing any gains or losses, if their fair value is determinable
within reasonable limits and the transaction has commercial substance.
A nonmonetary exchange has commercial substance if future cash flows
of the entity are expected to change significantly as a result of the
exchange. FAS 153 is effective for nonmonetary asset exchange
transactions occurring in periods beginning July 1, 2005. The adoption
of FAS 153 is not expected to have a significant impact on our
financial statements.
o FASB Staff Position (FSP) FAS 109-1, Application of FASB Statement No.
109, Accounting for Income Taxes, to the Tax Deduction on Qualified
Production Activities Provided by the American Jobs Creation Act of
2004, issued in December 2004, provides guidance on the application of
FAS 109 to the provision within the American Jobs Creation Act of 2004
that provides a tax deduction, beginning in 2005, on qualified
production activities, including a company's electric generation
activities. Under FSP FAS 109-1, recognition of the tax deduction on
qualified production activities is ordinarily reported in the year it
is earned. We are evaluating the impact on our financial position and
results of operations from the adoption of FSP FAS 109-1.
o FAS 151, Inventory Costs, issued November 2004, is an amendment of
Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory
Pricing. FAS 151 clarifies that abnormal amounts of idle facility
expense, freight, handling costs, and wasted materials (spoilage)
should be recognized as current-period charges. FAS 151 also requires
the allocation of fixed production overheads to inventory based on the
normal capacity of the production facilities. FAS 151 is effective for
inventory costs incurred beginning January 1, 2006. The adoption of
FAS 151 is not expected to have a significant impact on our financial
statements.
o FIN 46, Consolidation of Variable Interest Entities, was issued in
January 2003, and was subsequently revised in December 2003. The
guidance addresses when a company should include in its financial
K-64
statements the assets and liabilities of another entity. The primary
objectives of FIN 46 are to provide guidance on the identification of
entities for which control is achieved through means other than
through voting rights (variable interest entities) and to determine
when and which business enterprises should consolidate the variable
interest entity (primary beneficiary). FIN 46 requires that both the
primary beneficiary and all other enterprises with a significant
variable interest make additional disclosures. For public companies,
the revised FIN 46 is effective for financial periods ending after
March 15, 2004. Early application is permissible. Companies that
implemented FIN 46 prior to its revision may continue to apply that
guidance until the implementation date of the revision. The adoption
of FIN 46 and revisions did not and are not expected to have a
significant impact on our financial statements.
In July 2004, the Emerging Issues Task Force (EITF) reached a consensus on
Issue No. 02-14, Whether an Investor Should Apply the Equity Method of
Accounting to Investments Other Than Common Stock (EITF 02-14). EITF 02-14
concludes that an investor that has the ability to exercise significant
influence over the operating and financial policies of an investee should apply
the equity method of accounting only when it has an investment in common stock
or an investment that is in-substance common stock. EITF 02-14 is effective for
reporting periods beginning after September 15, 2004. The adoption of EITF 02-14
did not have a significant impact on our financial statements.
In June 2004, the EITF published Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF
03-1). EITF 03-1 provides application guidance on impairment of securities
accounted for under FAS 115, Accounting for Certain Investments in Debt and
Equity Securities, and cost method investments and requires certain quantitative
and qualitative disclosures for securities that are impaired at the balance
sheet date but for which an other-than-temporary impairment has not been
recognized. The disclosure requirements are effective for reporting periods
ending after December 31, 2003. The FASB issued FSP EITF Issue 03-1-1, Effective
Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments in
September 2004 delaying the effective date of the application guidance on
impairment of securities until the final issuance of FSP EITF Issue 03-1-a. The
adoption of EITF 03-1 is not expected to have a significant impact on our
financial statements.
In August 2003, the EITF published Issue No. 03-11, Reporting Realized
Gains and Losses on Derivative Instruments That Are Subject to FASB Statement
No. 133, Accounting for Derivative Instruments and Hedging Activities, and Not
"Held for Trading Purposes" as Defined in EITF Issue No. 02-3 (EITF 03-11). EITF
03-11 discusses whether realized gains and losses should be shown gross or net
in the income statement for contracts that are not held for trading purposes, as
defined in EITF 02-3, but are derivatives subject to FAS 133, Accounting for
Derivative Instruments and Hedging Activities. 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 December 31, 2004. See Note 7.
SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS
- ------------------------------------------
This Annual Report on Form 10-K contains forward-looking statements as
defined by the Private Securities Litigation Reform Act of 1995. UniSource
Energy and TEP are including the following cautionary statements to make
applicable and take advantage of the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995 for any forward-looking statements made
by or for UniSource Energy or TEP in this Annual Report on Form 10-K.
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
K-65
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 our unregulated
businesses.
12. Unanticipated changes in future liabilities relating to employee
benefit plans due to changes in market values of retirement plan
assets and health care costs.
13. The outcome of any ongoing or future litigation.
14. 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.
ITEM 7A. - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- ---------------------------------------------------------------------
MARKET RISKS
We are exposed to various forms of market risk. Changes in interest rates,
returns on marketable securities, and changes in commodity prices may affect our
future financial results.
For additional information concerning risk factors, including market risks,
see Safe Harbor for Forward-Looking Statements, above.
INTEREST RATE RISK
TEP is exposed to risk resulting from changes in interest rates on certain
of its variable rate debt obligations. At December 31, 2004 and 2003, TEP's debt
included $329 million of tax-exempt variable rate debt. The average interest
rate on TEP's variable rate debt (excluding letter of credit fees) was 1.25% in
2004 and 1.07% in 2003. TEP also has approximately $70 million in outstanding
principal amount of variable rate lease debt related to its Springerville Common
K-66
Facilities Leases. Interest on this lease debt is payable at LIBOR plus 4.25%.
The average interest rate on this lease debt was 5.92% in 2004 and 4.58% in
2003. A one percent increase (decrease) in average interest rates would result
in a decrease (increase) in TEP's pre-tax net income of approximately $4
million.
MARKETABLE SECURITIES RISK
TEP is exposed to fluctuations in the return on its marketable securities,
comprised of investments in debt securities. At December 31, 2004 and 2003, TEP
had marketable debt securities with an estimated fair value of $182 million and
$198 million. At December 31, 2004 and 2003, the fair value exceeded the
carrying value by $11 million and $19 million, respectively. These debt
securities represent TEP's investments in lease debt underlying certain of TEP's
capital lease obligations. Changes in the fair value of such debt securities do
not present a material risk to TEP, as TEP intends to hold these investments to
maturity.
RISK MANAGEMENT COMMITTEE
We have a Risk Management Committee responsible for the oversight commodity
price risk and credit risk related to the wholesale energy marketing activities
of TEP, the emissions and coal trading activities of MEG, and the fuel and power
procurement activities at TEP and UES. Our Risk Management Committee, which
meets on a quarterly basis and as needed, consists of officers from the finance,
accounting, legal, wholesale marketing, transmission and distribution
operations, 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.
COMMODITY PRICE RISK
We are exposed to commodity price risk primarily relating to changes in the
market price of electricity, natural gas, coal and Emission Allowances.
TEP
To manage its exposure to energy price risk, TEP enters into forward
contracts to buy or sell energy at a specified price and future delivery period.
Generally, TEP commits to future sales based on expected excess generating
capability, forward prices and generation costs, using a diversified market
approach to provide a balance between long-term, mid-term and spot energy sales.
TEP generally enters into forward purchases during its summer peaking period to
ensure it can meet its load and reserve requirements and account for other
contracts and resource contingencies. TEP also enters into limited forward
purchases and sales to optimize its resource portfolio and take advantage of
locational differences in price. These positions are managed on both a
volumetric and dollar basis and are closely monitored using risk management
policies and procedures overseen by the Risk Management Committee. For example,
the risk management policies provide that TEP should not take a short position
in the third quarter and must have owned generation backing up all forward sales
positions at the time the sale is made. TEP's risk management policies also
restrict entering into forward positions with maturities extending beyond the
end of the next calendar year.
The majority of TEP's forward contracts are considered to be "normal
purchases and sales" of electric energy and are not considered to be derivatives
under FAS 133. TEP records revenues on its "normal sales" and expenses on its
"normal purchases" in the period in which the energy is delivered. From time to
time, however, TEP enters into forward contracts that meet the definition of a
derivative under FAS 133. When TEP has derivative forward contracts, it marks
them to market on a daily basis using actively quoted prices obtained from
brokers for power traded over-the-counter at Palo Verde and at other
southwestern U.S. trading hubs. TEP believes that these broker quotations used
to calculate the mark-to-market values represent accurate measures of the fair
values of TEP's positions, because of the short-term nature of TEP's positions,
as limited by risk management policies, and the liquidity in the short-term
market. As of December 31, 2004, all of TEP's derivative forward contracts were
for settlement within 18 months. To adjust the value of its derivative forward
contracts to fair value on its income statement, TEP recorded an unrealized gain
of $1.3 million and an unrealized loss of $0.4 million, respectively, on its
income statements for the twelve months ended December 31, 2004 and December 31,
2003. This demonstrates the limited derivative forward contract activity
conducted by TEP and the limited impact on TEP's operating results and financial
condition.
K-67
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 and purchased power, in addition to energy from its coal-fired facilities,
to meet the summer peak demands of its retail customers and to meet local
reliability needs. Some of these purchased power contracts are price indexed to
natural gas prices. Short-term and spot power purchase prices are also closely
correlated to natural gas prices. Due to its increasing seasonal gas and
purchased power usage, TEP hedges a portion of its total natural gas exposure
from plant fuel, gas-indexed purchase power and spot market purchases with fixed
price contracts for a maximum of three years. TEP purchases its remaining gas
fuel needs and purchased power in the spot and short-term markets.
In 2004, the average price of natural gas was $5.44 per MMBtu, or 11%
higher than 2003, due to low gas storage levels and reductions in gas
production. The increase in the regional supply of gas-generated energy and the
completion of a 500-kV transmission connection, in May 2003, however, allowed
TEP to limit its 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 427,000 MWh, or 4% of total generation
and purchased power in 2004. During 2004, TEP purchased a total of 1,400,000 MWh
of energy, or 11% of total generation and purchased power, of which
approximately 175,000 MWh were from gas-index priced energy under long-term
purchased power contracts with the remainder being from short-term and spot
power markets.
In January 2005, TEP entered into a purchased power agreement with Panda
Gila River. TEP will purchase 50 MW of firm energy during June through September
2005.
TEP entered into two purchased power agreements in 2003 for the period 2003
through 2006. During 2003, TEP purchased approximately 125,000 MWh under these
contracts; energy purchased under these agreements is adjusted for changes in
the price of natural gas.
UES
UES is also subject to commodity price risk, primarily from the changes in
the price of natural gas purchased for its UNS Gas customers. This risk is
mitigated through the PGA mechanism in UNS Gas' retail rates which provides an
adjustment to recover the actual costs of gas and transportation. UNS Gas
further reduces this risk by purchasing forward fixed price contracts for a
portion of its projected gas needs under its Price Stabilization Plan. UNS Gas
purchases between 45% and 80% of its estimated gas needs in this manner.
UNS Electric is not exposed to commodity price risk for its purchase of
electricity as it has a fixed price full-requirements supply agreement with PWCC
through May 2008.
MEG
During the fourth quarter of 2001, MEG began managing and trading Emission
Allowances, coal and related instruments. We manage the market risk of this line
of business by setting notional limits by product, as well as limits to the
potential change in fair market value under a 33% change in price or volatility.
We closely monitor MEG's trading activities, which include swap agreements,
options and forward contracts, using risk management policies and procedures
overseen by the Risk Management Committee. MEG marks its trading positions to
market on a daily basis using actively quoted prices obtained from brokers and
options pricing models for positions that extend through 2007. As of December
31, 2004 and December 31, 2003, the fair value of MEG's trading assets combined
with Emission Allowances it holds in escrow was $76.5 million and $21.5 million,
respectively. The fair value of MEG's trading liabilities was $65 million at
December 31, 2004 and $18.7 million at December 31, 2003. During 2004, MEG
reflected a $0.6 million unrealized gain and $0.7 million realized gain on its
income statement, compared with an unrealized gain of $1.0 million and a
realized loss of $0.4 million in 2003.
Unrealized Gain (Loss) of MEG's Trading Activities
------------------------------------------------------
Total
Source of Fair Value Maturity Maturity Maturity Unrealized Gain
At December 31, 2004 0 - 6 mos. 6 -12 mos. over 1 yr. (Loss)
- Millions of Dollars -
Prices actively quoted $ (12.1) $ - $ - $ (12.1)
Prices based on models
and other valuation
methods 8.0 0.1 5.2 13.3
- --------------------------------------------------------------------------------
Total $ (4.1) $ 0.1 $ 5.2 $ 1.2
- --------------------------------------------------------------------------------
K-68
MEG is in the process of winding down its activities and will not engage in
any new activities after 2005. As of January 31, 2005, the fair value of MEG's
trading assets was $62 million and the fair value of its trading liabilities was
$56 million.
CREDIT RISK
UniSource Energy is exposed to credit risk in its energy-related marketing
and trading activities related to potential nonperformance by counterparties. We
manage the risk of counterparty default by performing financial credit reviews,
setting limits monitoring exposures, requiring collateral when needed, and using
a standard agreement which allows for the netting of current period exposures to
and from a single counterparty. Despite such mitigation efforts, there is a
potential for defaults by counterparties. In the fourth quarter of 2000 and the
first quarter of 2001, TEP was affected by payment defaults by SCE and PG&E for
amounts owed to the CPX and CISO. In the fourth quarter of 2001, Enron defaulted
on amounts owed to TEP for energy sales.
We calculate counterparty credit exposure by adding any outstanding
receivable (net of amounts payable if a netting agreement exists) to the
mark-to-market value of any forward contracts. As of December 31, 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 $17
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
32 counterparties. Approximately $3 million of exposure is to non-investment
grade companies. As a result of the reduction in MEG's trading activities
described above, MEG's credit exposure as of January 31, 2005, decreased to $6
million.
UniSource Energy is also exposed to credit risk related to the sale of
assets owned by Nations Energy Corporation (Nations Energy). In September 2001,
Nations Energy sold its 26% equity interest in a power project located in
Curacao, Netherlands Antilles to Mirant Curacao Investments, Ltd. (Mirant
Curacao) a subsidiary of Mirant Corporation (Mirant). Nations Energy received $5
million in cash and an $11 million note receivable from Mirant Curacao. The note
was recorded at its net present value of $8 million using an 8% discount rate,
the discount being recognized as interest income over the five-year life of the
note. As of December 31, 2004, Nations Energy's receivable from Mirant Curacao
is approximately $8 million. The note is primarily included in Investments and
Other Property-Other on UniSource Energy's balance sheet. The first payment of
$2 million on the receivable was received in July 2004. The remaining payments
on the note receivable are expected to be received as follows: $4 million in
July 2005; and $5 million in July 2006. The note is guaranteed by Mirant
Americas, Inc., a subsidiary of Mirant. On July 14, 2003, Mirant, Mirant
Americas, Inc. and various other Mirant companies filed for Chapter 11
bankruptcy protection. Mirant Curacao was not included in the Chapter 11
filings. Based on a review of the projected cash flows for the power project, it
appears Mirant Curacao will have sufficient future cash flows to pay the note
receivable and any applicable interest. However, we cannot predict the ultimate
outcome that Mirant's bankruptcy will have on the collectibility of the note
from Mirant Curacao. Nations Energy will continue to evaluate the collectibility
of the receivable, but currently expects to collect the note in its entirety and
has not recorded any reserve for this note.
ITEM 8. - CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
- --------------------------------------------------------------------------------
MANAGEMENT'S REPORT ON INTERNAL CONTROLS OVER FINANCIAL REPORTING
UniSource Energy Corporation's management is responsible for establishing
and maintaining adequate internal control over financial reporting. Because of
its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
Management assessed the effectiveness of UniSource Energy Corporation's
internal control over financial reporting as of December 31, 2004. In making
this assessment, management used the criteria set forth by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control -
Integrated Framework.
Based on management's assessment using those criteria, management has
concluded that, as of December 31, 2004, UniSource Energy Corporation's internal
control over financial reporting was effective.
K-69
Our management's assessment of the effectiveness of the Company's internal
control over financial reporting as of December 31, 2004 has been audited by
PricewaterhouseCoopers LLP, an independent registered public accounting firm, as
stated in their report which appears herein.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
UniSource Energy Corporation:
We have completed an integrated audit of UniSource Energy Corporation's 2004
financial statements and of its internal control over financial reporting as of
December 31, 2004 and audits of its 2003 and 2002 consolidated financial
statements in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Our opinions, based on our audits, are
presented below.
Consolidated financial statements and financial statement schedule
- ------------------------------------------------------------------
In our opinion, the consolidated financial statements listed in the index
appearing under Item 15(a)(1) present fairly, in all material respects, the
financial position of UniSource Energy Corporation and its subsidiaries at
December 31, 2004 and 2003, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2004 in
conformity with accounting principles generally accepted in the United States of
America. In addition, in our opinion, the financial statement schedule listed in
the index appearing under Item 15(a)(2) presents fairly, in all material
respects, the information set forth therein when read in conjunction with the
related consolidated financial statements. These financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits. We conducted our audits of
these statements in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit of financial statements
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
As described in Note 5 to the consolidated financial statements, the Company
changed the manner in which it accounts for asset retirement costs as of January
1, 2003.
Internal control over financial reporting
- -----------------------------------------
Also, in our opinion, management's assessment, included in Management's Report
on Internal Controls Over Financial Reporting appearing under Item 8, that the
Company maintained effective internal control over financial reporting as of
December 31, 2004 based on criteria established in Internal Control-Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO), is fairly stated, in all material respects, based on those
criteria. Furthermore, in our opinion, the Company maintained, in all material
respects, effective internal control over financial reporting as of December 31,
2004, based on criteria established in Internal Control-Integrated Framework
issued by the COSO. The Company's management is responsible for maintaining
effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting. Our
responsibility is to express opinions on management's assessment and on the
effectiveness of the Company's internal control over financial reporting based
on our audit. We conducted our audit of internal control over financial
reporting in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. An audit of internal control over financial reporting includes
obtaining an understanding of internal control over financial reporting,
evaluating management's assessment, testing and evaluating the design and
operating effectiveness of internal control, and performing such other
procedures as we consider necessary in the circumstances. We believe that our
audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (i) pertain to
K-70
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (ii)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
- ------------------------------
PricewaterhouseCoopers LLP
Los Angeles, California
March 16, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Tucson Electric Power Company:
In our opinion, the consolidated financial statements listed in the index
appearing under Item 15(a)(1) present fairly, in all material respects, the
financial position of Tucson Electric Power Company and its subsidiaries at
December 31, 2004 and 2003, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2004 in
conformity with accounting principles generally accepted in the United States of
America. In addition, in our opinion, the financial statement schedule listed in
the index appearing under Item 15(a)(2) presents fairly, in all material
respects, the information set forth therein when read in conjunction with the
related consolidated financial statements. These financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits. We conducted our audits of
these statements in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
As described in Note 5 to the consolidated financial statements, the Company
changed the manner in which it accounts for asset retirement costs as of January
1, 2003.
/s/ PricewaterhouseCoopers LLP
- ------------------------------
PricewaterhouseCoopers LLP
Los Angeles, California
March 16, 2005
K-71
UNISOURCE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31,
2004 2003 2002
- ------------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
OPERATING REVENUES
Electric Retail Sales $ 862,258 $ 746,578 $ 668,721
Electric Wholesale Sales 160,154 151,111 157,108
Gas Revenue 126,666 46,520 -
Other Revenues 19,900 28,546 13,747
- ------------------------------------------------------------------------------------------------------------------
TOTAL OPERATING REVENUES 1,168,978 972,755 839,576
- ------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSES
Fuel 212,514 210,163 209,712
Purchased Energy 250,668 132,754 43,171
Coal Contract Termination Fee - - 11,250
Other Operations and Maintenance 252,711 216,323 188,910
Depreciation and Amortization 135,315 130,643 127,923
Amortization of Transition Recovery Asset 50,153 31,752 24,489
Taxes Other Than Income Taxes 48,227 48,115 45,508
- ------------------------------------------------------------------------------------------------------------------
TOTAL OPERATING EXPENSES 949,588 769,750 650,963
- ------------------------------------------------------------------------------------------------------------------
OPERATING INCOME 219,390 203,005 188,613
- ------------------------------------------------------------------------------------------------------------------
OTHER INCOME (DEDUCTIONS)
Interest Income 20,192 20,493 20,654
Other Income 15,030 7,306 6,200
Other Expense (6,439) (5,620) (8,026)
- ------------------------------------------------------------------------------------------------------------------
TOTAL OTHER INCOME (DEDUCTIONS) 28,783 22,179 18,828
- ------------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Long-Term Debt 82,807 80,844 65,620
Interest on Capital Leases 85,912 84,080 87,801
Other Interest Expense, Net of Amounts Capitalized (411) 1,708 1,130
- ------------------------------------------------------------------------------------------------------------------
TOTAL INTEREST EXPENSE 168,308 166,632 154,551
- ------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE 79,865 58,552 52,890
Income Tax Expense 33,946 12,082 17,962
- ------------------------------------------------------------------------------------------------------------------
INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE 45,919 46,470 34,928
CUMULATIVE EFFECT OF ACCOUNTING CHANGE - NET OF TAX - 67,471 -
- ------------------------------------------------------------------------------------------------------------------
NET INCOME $ 45,919 $ 113,941 $ 34,928
==================================================================================================================
WEIGHTED-AVERAGE SHARES OF COMMON STOCK OUTSTANDING (000) 34,380 33,828 33,665
==================================================================================================================
BASIC EARNINGS PER SHARE
INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE $1.34 $1.38 $1.04
CUMULATIVE EFFECT OF ACCOUNTING CHANGE - NET OF TAX - $1.99 -
- ------------------------------------------------------------------------------------------------------------------
NET INCOME $1.34 $3.37 $1.04
==================================================================================================================
DILUTED EARNINGS PER SHARE
INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE $1.31 $1.35 $1.02
CUMULATIVE EFFECT OF ACCOUNTING CHANGE - NET OF TAX - $1.97 -
- ------------------------------------------------------------------------------------------------------------------
NET INCOME $1.31 $3.32 $1.02
==================================================================================================================
DIVIDENDS PAID PER SHARE $0.64 $0.60 $0.50
==================================================================================================================
See Notes to Consolidated Financial Statements.
K-72
UNISOURCE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
2004 2003 2002
- ------------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
CASH FLOWS FROM OPERATING ACTIVITIES
Cash Receipts from Electric Retail Sales $ 931,450 $ 814,425 $ 731,404
Cash Receipts from Electric Wholesale Sales 204,902 203,717 248,305
Cash Receipts from Gas Sales 136,386 38,306 -
Other Cash Receipts 18,837 11,982 28,047
MEG Cash Receipts from Trading Activity 170,506 101,368 57,889
UED Springerville 3 Financial Closing Proceeds - 43,265 -
Interest Received 22,608 22,428 13,820
Income Tax Refunds Received 5,427 17,093 921
Deposit-Second Mortgage Indenture 17,040 (17,040) -
Fuel Costs Paid (208,549) (204,920) (201,124)
Purchased Energy Costs Paid (286,115) (187,933) (135,320)
Wages Paid, Net of Amounts Capitalized (92,781) (82,482) (75,479)
Payment of Other Operations and Maintenance Costs (124,786) (114,864) (124,417)
MEG Cash Payments for Trading Activity (162,609) (100,963) (63,766)
Capital Lease Interest Paid (70,752) (74,865) (68,975)
Taxes Paid, Net of Amounts Capitalized (139,637) (110,391) (106,550)
Interest Paid, Net of Amounts Capitalized (75,957) (73,565) (62,241)
Income Taxes Paid (20,483) (6,716) (29,238)
Coal Contract Termination and Amendment Fees Paid - - (26,649)
Performance Deposits (6,487) (3,124) 6,147
Other Cash Payments (12,021) (12,325) (16,337)
- ------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES 306,979 263,396 176,437
- ------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital Expenditures (153,684) (137,282) (112,706)
Capital Expenditure for Luna Energy Facility Assets (13,333) - -
Purchase of Citizens Assets - (223,430) -
Proceeds from Investment in Springerville Lease Debt and Equity 11,590 12,078 3,078
Return of Investment from Millennium Energy Businesses 10,120 - -
Other Proceeds from Investing Activities 2,712 1,876 1,590
Payments for Investment in Springerville Lease Debt and Equity (4,499) - (138,067)
Investments in and Loans to Equity Investees (4,095) (2,072) (23,592)
Other Payments for Investing Activities (5,000) (1,902) (1,193)
- ------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - INVESTING ACTIVITIES (156,189) (350,732) (270,890)
- ------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Payments of Capital Lease Obligations (49,378) (42,657) (19,842)
Repayment of Long-Term Debt (28,732) (2,976) (2,138)
Payment of Debt Issue Costs (9,364) (3,283) (5,410)
Proceeds from Borrowings under the Revolving Credit Facility 20,000 45,000 -
Payments for Borrowings under the Revolving Credit Facility (20,000) (45,000) -
Proceeds from Issuance of Short-Term Debt - 36,125 1,194
Repayments of Short-Term Debt - (35,960) (1,078)
Proceeds from Issuance of Long-Term Debt - 160,000 -
Common Stock Dividends Paid (21,879) (20,208) (16,806)
Other Proceeds from Financing Activities 12,657 7,949 2,249
Other Payments for Financing Activities (1,332) (1,316) (942)
- ------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - FINANCING ACTIVITIES (98,028) 97,674 (42,773)
- ------------------------------------------------------------------------------------------------------------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 52,762 10,338 (137,226)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 101,266 90,928 228,154
- ------------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 154,028 $ 101,266 $ 90,928
==================================================================================================================
See Note 20 for supplemental cash flow information.
See Notes to Consolidated Financial Statements.
K-73
UNISOURCE ENERGY CORPORATION
CONSOLIDATED BALANCE SHEETS
December 31,
2004 2003
- -----------------------------------------------------------------------------------------------------
ASSETS - Thousands of Dollars -
UTILITY PLANT
Plant in Service $ 3,033,405 $ 2,899,305
Utility Plant under Capital Leases 723,901 748,239
Construction Work in Progress 116,161 105,804
- -----------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT 3,873,467 3,753,348
Less Accumulated Depreciation and Amortization (1,348,017) (1,262,962)
Less Accumulated Amortization of Capital Lease Assets (444,313) (421,171)
- -----------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT - NET 2,081,137 2,069,215
- -----------------------------------------------------------------------------------------------------
INVESTMENTS AND OTHER PROPERTY
Investments in Lease Debt 170,893 178,789
Other 85,035 109,570
- -----------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS AND OTHER PROPERTY 255,928 288,359
- -----------------------------------------------------------------------------------------------------
CURRENT ASSETS
Cash and Cash Equivalents 154,028 101,266
Trade Accounts Receivable 107,694 97,904
Unbilled Accounts Receivable 55,350 53,590
Allowance for Doubtful Accounts (16,492) (11,522)
Materials and Fuel Inventory 62,225 58,299
Trading Assets 70,958 19,987
Current Regulatory Assets 11,515 12,129
Deferred Income Taxes - Current 24,055 15,925
Interest Receivable - Current 10,475 11,561
Other 26,751 21,534
- -----------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 506,559 380,673
- -----------------------------------------------------------------------------------------------------
REGULATORY AND OTHER ASSETS
Transition Recovery Asset 224,029 274,182
Income Taxes Recoverable Through Future Revenues 44,624 49,849
Other Regulatory Assets 13,961 12,327
Other Assets 49,280 48,114
- -----------------------------------------------------------------------------------------------------
TOTAL REGULATORY AND OTHER ASSETS 331,894 384,472
- -----------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 3,175,518 $ 3,122,719
=====================================================================================================
CAPITALIZATION AND OTHER LIABILITIES
CAPITALIZATION
Common Stock Equity $ 580,718 $ 556,472
Capital Lease Obligations 701,931 762,968
Long-Term Debt 1,257,595 1,286,320
- -----------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION 2,540,244 2,605,760
- -----------------------------------------------------------------------------------------------------
CURRENT LIABILITIES
Current Obligations under Capital Leases 53,694 50,269
Current Maturities of Long-Term Debt 1,725 1,742
Accounts Payable 95,276 65,745
Interest Accrued 60,679 62,927
Trading Liabilities 65,022 18,238
Taxes Accrued 53,192 50,625
Accrued Employee Expenses 19,216 16,081
Other 19,350 16,256
- -----------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 368,154 281,883
- -----------------------------------------------------------------------------------------------------
DEFERRED CREDITS AND OTHER LIABILITIES
Deferred Income Taxes - Noncurrent 101,753 96,270
Regulatory Liability - Net Cost of Removal for Interim Retirements 69,585 60,998
Other 95,782 77,808
- -----------------------------------------------------------------------------------------------------
TOTAL DEFERRED CREDITS AND OTHER LIABILITIES 267,120 235,076
- -----------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES (NOTE 8)
- -----------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION AND OTHER LIABILITIES $ 3,175,518 $ 3,122,719
=====================================================================================================
See Notes to Consolidated Financial Statements.
K-74
UNISOURCE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF CAPITALIZATION
December 31,
2004 2003
- ---------------------------------------------------------------------------------------------------------------------------
COMMON STOCK EQUITY - Thousands of Dollars -
Common Stock--No Par Value $ 677,119 $ 668,022
2004 2003
------------------------------------
Shares Authorized 75,000,000 75,000,000
Shares Outstanding 34,255,070 33,787,942
Accumulated Deficit (85,666) (109,706)
Accumulated Other Comprehensive Loss (10,735) (1,844)
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCK EQUITY 580,718 556,472
- ---------------------------------------------------------------------------------------------------------------------------
PREFERRED STOCK
No Par Value, 1,000,000 Shares Authorized, None Outstanding - -
- ---------------------------------------------------------------------------------------------------------------------------
CAPITAL LEASE OBLIGATIONS
Springerville Unit 1 459,815 484,219
Springerville Coal Handling Facilities 126,538 129,415
Springerville Common Facilities 105,529 125,717
Sundt Unit 4 62,607 72,196
Other Leases 1,136 1,690
- ---------------------------------------------------------------------------------------------------------------------------
Total Capital Lease Obligations 755,625 813,237
Less Current Maturities (53,694) (50,269)
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL LONG-TERM CAPITAL LEASE OBLIGATIONS 701,931 762,968
- ---------------------------------------------------------------------------------------------------------------------------
LONG-TERM DEBT
ISSUE MATURITY INTEREST RATE
- ---------------------------------------------------------------------------------------------------------------------------
First Mortgage Bonds
Corporate 2009 8.50% - 27,000
Industrial Development Revenue Bonds (IDBs) 2006 - 2008 6.10% to 7.50% 53,150 54,875
First Collateral Trust Bonds 2008 7.50% 138,300 138,300
Second Mortgage IDBs* 2018 - 2022 Variable** 328,600 328,600
Unsecured IDBs 2020 - 2033 5.85% to 7.13% 579,270 579,270
Senior Unsecured Notes 2008 - 2015 6.23% to 7.61% 160,000 160,000
Other Long-Term Debt - 17
- ---------------------------------------------------------------------------------------------------------------------------
Total Stated Principal Amount 1,259,320 1,288,062
Less Current Maturities (1,725) (1,742)
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL LONG-TERM DEBT 1,257,595 1,286,320
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION $ 2,540,244 $ 2,605,760
===========================================================================================================================
* The Second Mortgage IDBs (defined below) are backed by $341 million of LOCs
under TEP's Credit Agreement. TEP's obligations under the Credit Agreement are
collateralized with Second Mortgage Bonds. At December 31, 2004, the annual LOC
fees (including fronting fees) were 2.60%. At December 31, 2003, the annual LOC
fees (including fronting fees) ranged from 4.25% to 5.75%. See Note 10.
** Weighted average interest rates on variable rate tax-exempt debt (IDBs)
ranged from 0.78% to 2.01% during 2004 and 2003, and the average interest rate
on such debt was 1.25% in 2004 and 1.07% in 2003.
UniSource Energy also has stock options outstanding. See Note 17.
See Notes to Consolidated Financial Statements.
K-75
UNISOURCE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
ACCUMULATED
COMMON ACCUMULATED OTHER TOTAL
SHARES COMMON EARNINGS COMPREHENSIVE STOCKHOLDERS'
OUTSTANDING* STOCK (DEFICIT) INCOME (LOSS) EQUITY
- ------------------------------------------------------------------------------------------------------------------------------
- In Thousands -
BALANCES AT DECEMBER 31, 2001 33,502 $ 662,694 $ (221,561) $ - $ 441,133
Comprehensive Income:
2002 Net Income - - 34,928 - 34,928
Minimum Pension Liability
(net of $2,639 income tax benefit) - - - (4,024) (4,024)
------------
Total Comprehensive Income 30,904
------------
Dividends Declared - - (16,806) - (16,806)
Shares Issued under Stock Compensation Plans 9 80 - - 80
Shares Distributed by Deferred Compensation Trust 3 48 - - 48
Shares Issued for Stock Options 65 934 - - 934
Other - 347 - - 347
- ---------------------------------------------------------------------------------------------------------------------------
BALANCES AT DECEMBER 31, 2002 33,579 664,103 (203,439) (4,024) 456,640
Comprehensive Income:
2003 Net Income - - 113,941 - 113,941
Minimum Pension Liability Adjustment
(net of $1,430 income tax expense) - - - 2,180 2,180
------------
Total Comprehensive Income 116,121
------------
Dividends Declared - - (20,208) - (20,208)
Shares Issued under Stock Compensation Plans 7 55 - - 55
Shares Distributed by Deferred Compensation Trust 3 52 - - 52
Shares Issued for Stock Options 199 3,489 - - 3,489
Other - 323 - - 323
- ---------------------------------------------------------------------------------------------------------------------------
BALANCES AT DECEMBER 31, 2003 33,788 668,022 (109,706) (1,844) 556,472
Comprehensive Income:
2004 Net Income - - 45,919 - 45,919
Minimum Pension Liability Adjustment
(net of $6,858 income tax benefit) - - - (10,460) (10,460)
Unrealized Gain on Cash Flow Hedges
(net of $960 income tax expense) - - - 1,465 1,465
Reclassification of Realized Loss on
Cash Flow Hedges to Net Income
(net of $68 income tax benefit) - - - 104 104
------------
Total Comprehensive Income 37,028
------------
Dividends Declared - - (21,879) - (21,879)
Shares Issued under Stock Compensation Plans 63 1,307 - - 1,307
Shares Distributed by Deferred Compensation Trust 4 50 - - 50
Shares Issued for Stock Options 400 7,576 - - 7,576
Other - 164 - - 164
- ---------------------------------------------------------------------------------------------------------------------------
BALANCES AT DECEMBER 31, 2004 34,255 $ 677,119 $ (85,666) $ (10,735) $ 580,718
===========================================================================================================================
* UniSource Energy has 75 million authorized shares of common stock.
We describe limitations on our ability to pay dividends in Note 12.
See Notes to Consolidated Financial Statements.
K-76
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31,
2004 2003 2002
- ----------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
OPERATING REVENUES
Electric Retail Sales $ 719,341 $ 691,503 $ 668,721
Electric Wholesale Sales 159,918 151,030 157,108
Other Revenues 10,039 9,018 8,618
- ----------------------------------------------------------------------------------------------------------
TOTAL OPERATING REVENUES 889,298 851,551 834,447
- ----------------------------------------------------------------------------------------------------------
OPERATING EXPENSES
Fuel 212,514 210,163 209,712
Purchased Power 72,558 65,127 43,171
Coal Contract Termination Fee - - 11,250
Other Operations and Maintenance 190,347 170,086 163,084
Depreciation and Amortization 117,109 121,037 124,054
Amortization of Transition Recovery Asset 50,153 31,752 24,489
Taxes Other Than Income Taxes 39,933 42,388 44,228
- ----------------------------------------------------------------------------------------------------------
TOTAL OPERATING EXPENSES 682,614 640,553 619,988
- ----------------------------------------------------------------------------------------------------------
OPERATING INCOME 206,684 210,998 214,459
- ----------------------------------------------------------------------------------------------------------
OTHER INCOME (DEDUCTIONS)
Interest Income 20,021 20,328 20,094
Interest Income - Note Receivable from UniSource Energy 9,329 10,242 9,329
Other Income 6,520 3,272 3,570
Other Expense (4,600) (1,604) (1,779)
- ----------------------------------------------------------------------------------------------------------
TOTAL OTHER INCOME (DEDUCTIONS) 31,270 32,238 31,214
- ----------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Long-Term Debt 71,743 76,585 65,620
Interest on Capital Leases 85,869 84,053 87,783
Other Interest Expense, Net of Amounts Capitalized (600) 66 446
- ----------------------------------------------------------------------------------------------------------
TOTAL INTEREST EXPENSE 157,012 160,704 153,849
- ----------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES AND
CUMULATIVE EFFECT OF ACCOUNTING CHANGE 80,942 82,532 91,824
Income Tax Expense 34,815 21,090 36,434
- ----------------------------------------------------------------------------------------------------------
INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE 46,127 61,442 55,390
CUMULATIVE EFFECT OF ACCOUNTING CHANGE - NET OF TAX - 67,471 -
- ----------------------------------------------------------------------------------------------------------
NET INCOME $ 46,127 $ 128,913 $ 55,390
==========================================================================================================
See Notes to Consolidated Financial Statements.
K-77
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
2004 2003 2002
- --------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
CASH FLOWS FROM OPERATING ACTIVITIES
Cash Receipts from Electric Retail Sales $ 780,335 $ 753,424 $ 731,404
Cash Receipts from Electric Wholesale Sales 204,643 203,644 248,305
Interest Received 21,928 22,049 13,288
Interest Received from UniSource Energy - 19,571 -
Income Tax Refunds Received 3,712 16,926 921
Deposit-Second Mortgage Indenture 17,040 (17,040) -
Other Cash Receipts 8,720 3,935 4,975
Fuel Costs Paid (208,549) (204,920) (201,124)
Purchased Power Costs Paid (115,323) (119,635) (135,320)
Wages Paid, Net of Amounts Capitalized (68,832) (63,409) (60,871)
Payment of Other Operations and Maintenance Costs (99,382) (96,380) (103,638)
Capital Lease Interest Paid (70,748) (74,851) (68,911)
Taxes Paid, Net of Amounts Capitalized (102,648) (100,622) (101,866)
Interest Paid, Net of Amounts Capitalized (65,504) (73,071) (62,209)
Income Taxes Paid (21,402) (5,230) (29,109)
Coal Contract Termination and Amendment Fees Paid - - (26,649)
Other Cash Payments (8,839) (3,402) (2,205)
- --------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES 275,151 260,989 206,991
- --------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital Expenditures (116,172) (121,854) (103,307)
Capital Expenditure for Luna Energy Facility Assets (13,333) - -
Proceeds from Investment in Springerville Lease Debt and Equity 11,590 12,078 3,078
Other Proceeds from Investing Activities 1,652 1,232 -
Payments for Investment in Springerville Lease Debt and Equity (4,499) - (138,067)
Purchase of North Loop Gas Turbine from UED - - (14,853)
Other Payments for Investing Activities (5,000) (1,902) (1,193)
- --------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - INVESTING ACTIVITIES (125,762) (110,446) (254,342)
- --------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Payments of Capital Lease Obligations (49,431) (42,553) (19,544)
Repayments of Long-Term Debt (28,725) (2,090) (2,114)
Proceeds from Borrowings under Revolving Credit Facility 20,000 45,000 -
Payments for Borrowings under Revolving Credit Facility (20,000) (45,000) -
Payment of Debt Issue Costs (8,890) (788) (5,410)
Dividends Paid to UniSource Energy (31,500) (80,000) (35,000)
Other Proceeds from Financing Activities 18,435 1,916 6,458
Other Payments for Financing Activities (1,333) (17,544) (941)
- --------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - FINANCING ACTIVITIES (101,444) (141,059) (56,551)
- --------------------------------------------------------------------------------------------------------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 47,945 9,484 (103,902)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 65,262 55,778 159,680
- --------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 113,207 $ 65,262 $ 55,778
==============================================================================================================
See Note 20 for supplemental cash flow information.
See Notes to Consolidated Financial Statements.
K-78
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED BALANCE SHEETS
December 31,
2004 2003
- -----------------------------------------------------------------------------------------------------------
ASSETS - Thousands of Dollars -
UTILITY PLANT
Plant in Service $ 2,771,665 $ 2,681,133
Utility Plant under Capital Leases 723,195 747,533
Construction Work in Progress 94,336 82,210
- -----------------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT 3,589,196 3,510,876
Less Accumulated Depreciation and Amortization (1,328,228) (1,257,585)
Less Accumulated Amortization of Capital Lease Assets (444,186) (421,135)
- -----------------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT - NET 1,816,782 1,832,156
- -----------------------------------------------------------------------------------------------------------
INVESTMENTS AND OTHER PROPERTY
Investments in Lease Debt 170,893 178,789
Other 23,393 41,285
- -----------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS AND OTHER PROPERTY 194,286 220,074
- -----------------------------------------------------------------------------------------------------------
NOTE RECEIVABLE FROM UNISOURCE ENERGY 79,462 70,132
- -----------------------------------------------------------------------------------------------------------
CURRENT ASSETS
Cash and Cash Equivalents 113,207 65,262
Trade Accounts Receivable 72,042 70,415
Unbilled Accounts Receivable 33,179 31,104
Allowance for Doubtful Accounts (14,166) (11,034)
Intercompany Accounts Receivable 10,111 10,938
Materials and Fuel Inventory 51,207 50,107
Current Regulatory Assets 9,653 8,969
Deferred Income Taxes - Current 24,157 18,847
Interest Receivable - Current 10,475 11,561
Other 18,330 8,861
- -----------------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 328,195 265,030
- -----------------------------------------------------------------------------------------------------------
REGULATORY AND OTHER ASSETS
Transition Recovery Asset 224,029 274,182
Income Taxes Recoverable Through Future Revenues 44,624 49,849
Other Regulatory Assets 13,684 11,973
Other Assets 41,106 43,651
- -----------------------------------------------------------------------------------------------------------
TOTAL REGULATORY AND OTHER ASSETS 323,443 379,655
- -----------------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 2,742,168 $ 2,767,047
===========================================================================================================
CAPITALIZATION AND OTHER LIABILITIES
CAPITALIZATION
Common Stock Equity $ 414,510 $ 406,054
Capital Lease Obligations 701,405 762,323
Long-Term Debt 1,097,595 1,126,320
- ------------------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION 2,213,510 2,294,697
- ------------------------------------------------------------------------------------------------------------
CURRENT LIABILITIES
Current Obligations under Capital Leases 53,611 50,126
Current Maturities of Long-Term Debt 1,725 1,725
Accounts Payable 46,377 37,998
Intercompany Accounts Payable 20,026 8,413
Interest Accrued 56,514 58,620
Taxes Accrued 44,938 38,024
Accrued Employee Expenses 17,594 14,716
Other 9,592 8,480
- ------------------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 250,377 218,102
- ------------------------------------------------------------------------------------------------------------
DEFERRED CREDITS AND OTHER LIABILITIES
Deferred Income Taxes - Noncurrent 129,842 128,336
Regulatory Liability - Net Cost of Removal for Interim Retirements 67,485 60,417
Other 80,954 65,495
- ------------------------------------------------------------------------------------------------------------
TOTAL DEFERRED CREDITS AND OTHER LIABILITIES 278,281 254,248
- ------------------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES (NOTE 8)
- ------------------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION AND OTHER LIABILITIES $ 2,742,168 $ 2,767,047
============================================================================================================
See Notes to Consolidated Financial Statements.
K-79
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED STATEMENTS OF CAPITALIZATION
December 31,
2004 2003
- ---------------------------------------------------------------------------------------------------------------------------------
COMMON STOCK EQUITY - Thousands of Dollars -
Common Stock--No Par Value $ 658,254 $ 655,534
2004 2003
--------------------------------
Shares Authorized 75,000,000 75,000,000
Shares Outstanding* 32,139,555 32,139,555
Capital Stock Expense (6,357) (6,357)
Accumulated Deficit (226,652) (241,279)
Accumulated Other Comprehensive Loss (10,735) (1,844)
- ----------------------------------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCK EQUITY 414,510 406,054
- ----------------------------------------------------------------------------------------------------------------------------------
PREFERRED STOCK
No Par Value, 1,000,000 Shares Authorized, None Outstanding - -
- ----------------------------------------------------------------------------------------------------------------------------------
CAPITAL LEASE OBLIGATIONS
Springerville Unit 1 459,815 484,219
Springerville Coal Handling Facilities 126,538 129,415
Springerville Common Facilities 105,529 125,717
Sundt Unit 4 62,607 72,196
Other Leases 527 902
- ----------------------------------------------------------------------------------------------------------------------------------
Total Capital Lease Obligations 755,016 812,449
Less Current Maturities (53,611) (50,126)
- ----------------------------------------------------------------------------------------------------------------------------------
TOTAL LONG-TERM CAPITAL LEASE OBLIGATIONS 701,405 762,323
- ----------------------------------------------------------------------------------------------------------------------------------
LONG-TERM DEBT
ISSUE MATURITY INTEREST RATE
- ----------------------------------------------------------------------------------------------------------------------------------
First Mortgage Bonds
Corporate 2009 8.50% - 27,000
Industrial Development Revenue Bonds (IDBs) 2006 - 2008 6.10% to 7.50% 53,150 54,875
First Collateral Trust Bonds 2008 7.50% 138,300 138,300
Second Mortgage IDBs** 2018 - 2022 Variable*** 328,600 328,600
Unsecured IDBs 2020 - 2033 5.85% to 7.13% 579,270 579,270
- ----------------------------------------------------------------------------------------------------------------------------------
Total Stated Principal Amount 1,099,320 1,128,045
Less Current Maturities (1,725) (1,725)
- ----------------------------------------------------------------------------------------------------------------------------------
TOTAL LONG-TERM DEBT 1,097,595 1,126,320
- ----------------------------------------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION $ 2,213,510 $ 2,294,697
==================================================================================================================================
* UniSource Energy is the holder of all but 121 shares of TEP's outstanding
common stock.
** The Second Mortgage IDBs are backed by $341 million of LOCs under TEP's
Credit Agreement. TEP's obligations under the Credit Agreement are
collateralized with Second Mortgage Bonds. At December 31, 2004, the annual LOC
fees (including fronting fees) were 2.60%. At December 31, 2003, the annual LOC
fees (including fronting fees) ranged from 4.25% to 5.75%. See Note 10.
*** Weighted average interest rates on variable rate tax-exempt debt (IDBs)
ranged from 0.78% to 2.01% during 2004 and 2003, and the average interest rate
on such debt was 1.25% in 2004 and 1.07% in 2003.
See Notes to Consolidated Financial Statements.
K-80
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
ACCUMULATED
CAPITAL ACCUMULATED OTHER TOTAL
COMMON STOCK EARNINGS COMPREHENSIVE STOCKHOLDERS'
STOCK EXPENSE (DEFICIT) INCOME (LOSS) EQUITY
- -----------------------------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
BALANCES AT DECEMBER 31, 2001 $ 654,021 $ (6,357) $ (310,582) $ - $ 337,082
Comprehensive Income:
2002 Net Income - - 55,390 - 55,390
Minimum Pension Liability
(net of $2,639 income tax benefit) - - - (4,024) (4,024)
-----------
Total Comprehensive Income 51,366
-----------
Dividends Paid - - (35,000) - (35,000)
Capital Contribution from UniSource Energy 346 - - - 346
Other 38 - - - 38
- ----------------------------------------------------------------------------------------------------------------------------------
BALANCES AT DECEMBER 31, 2002 654,405 (6,357) (290,192) (4,024) 353,832
Comprehensive Income:
2003 Net Income - - 128,913 - 128,913
Minimum Pension Liability Adjustment
(net of $1,430 income tax expense) - - - 2,180 2,180
-----------
Total Comprehensive Income 131,093
-----------
Dividends Paid - - (80,000) - (80,000)
Capital Contribution from UniSource Energy 1,129 - - - 1,129
- ----------------------------------------------------------------------------------------------------------------------------------
BALANCES AT DECEMBER 31, 2003 655,534 (6,357) (241,279) (1,844) 406,054
Comprehensive Income:
2004 Net Income - - 46,127 - 46,127
Minimum Pension Liability Adjustment
(net of $6,858 income tax benefit) - - - (10,460) (10,460)
Unrealized Gain on Cash Flow Hedges
(net of $960 income tax expense) - - - 1,465 1,465
Reclassification of Realized Loss on
Cash Flow Hedges to Net Income
(net of $68 income tax benefit) - - - 104 104
-----------
Total Comprehensive Income 37,236
-----------
Dividends Paid - - (31,500) - (31,500)
Capital Contribution from UniSource Energy 2,720 - - - 2,720
- ----------------------------------------------------------------------------------------------------------------------------------
BALANCES AT DECEMBER 31, 2004 $ 658,254 $ (6,357) $ (226,652) $ (10,735) $ 414,510
===================================================================================================================================
We describe limitations on TEP's ability to pay dividends in Note 12.
See Notes to Consolidated Financial Statements.
K-81
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
NOTE 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
- ----------------------------------------------------------------------------
NATURE OF OPERATIONS
UniSource Energy Corporation (UniSource Energy) is an exempt holding
company under the Public Utility Holding Company Act of 1935. UniSource Energy
has no significant operations of its own, but owns substantially all of the
common stock of Tucson Electric Power Company (TEP) and all of the common stock
of UniSource Energy Services, Inc. (UES), Millennium Energy Holdings, Inc.
(Millennium) and UniSource Energy Development Company (UED).
TEP, a regulated public utility incorporated in Arizona since 1963, is
UniSource Energy's largest operating subsidiary and represented approximately
84% of UniSource Energy's assets as of December 31, 2004. TEP generates,
transmits and distributes electricity. TEP serves approximately 375,000 retail
electric customers in a 1,155 square mile area in Southern Arizona. TEP also
sells electricity to other utilities and power marketing entities primarily
located in the western U.S.
On August 11, 2003, UniSource Energy completed the purchase of the Arizona
gas and electric system assets from Citizens Communications Company (Citizens)
and established UES to hold such assets. UES' businesses are described in Note
3.
Millennium's unregulated businesses and UED's services are described in
Note 6.
References to "we" and "our" are to UniSource Energy and its subsidiaries,
collectively.
BASIS OF PRESENTATION
We use the following accounting methods to report investments in
subsidiaries or other companies:
o CONSOLIDATION: The consolidation method is used where a majority
of the voting stock of a subsidiary is held and control over the
subsidiary is exercised. The accounts of the subsidiary are
combined with the accounts of the parent and intercompany
balances and transactions are eliminated.
o THE EQUITY METHOD: The equity method is used to report corporate
joint ventures, partnerships, and affiliated company investments
when the ability to exercise significant influence over the
operating and financial policies of an investee company is
demonstrated. The equity method is typically used when 20% to 50%
of the voting interest is held. Under the equity method:
+ The investment appears on a single line item on the balance
sheet; and
+ The net income (loss) from the entity is reflected in Other
Income on the income statements. For investments where UniSource
Energy, TEP, UES or Millennium is committed to providing all of
the financing, they recognize 100% of the losses.
o THE COST METHOD: The cost method is used when not enough shares
are owned to exercise significant influence over an investee
company. Typically the cost method is used for investments of
less than 20% of the voting interest in an investee company.
Under the cost method:
+ The investment appears on a single line item on the balance
sheet; and
+ Income from investee dividend distributions is reflected as Other
Income on the income statements; and
+ Loss is included in Other Income on the income statements when
impairment of the value of the investment is other than
temporary.
USE OF ACCOUNTING ESTIMATES
Management makes estimates and assumptions when preparing financial
statements under accounting principles generally accepted in the United States
of America (GAAP). These estimates and assumptions affect:
K-94
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
o A portion of the reported amounts of assets and liabilities at
the dates of the financial statements;
o Our disclosures regarding contingent assets and liabilities at
the dates of the financial statements; and
o A portion of the reported revenues and expenses during the
financial statement reporting periods.
Because these estimates involve judgments, the actual amounts may differ
from the estimates.
ACCOUNTING FOR RATE REGULATION
The Arizona Corporation Commission (ACC) and the Federal Energy Regulatory
Commission (FERC) regulate portions of TEP's, UNS Gas' and UNS Electric's
utility accounting practices and rates. The ACC has authority over certain rates
charged to retail customers, the issuance of securities, and transactions with
affiliated parties. The FERC regulates TEP's and UNS Electric's rates for
wholesale power sales and transmission services.
TEP, UNS Gas and UNS Electric generally use the same accounting policies
and practices used by unregulated companies for financial reporting under GAAP.
However, sometimes these principles, such as the Financial Accounting Standards
Board's (FASB) Statement of Financial Accounting Standards No. 71, Accounting
for the Effects of Certain Types of Regulation (FAS 71), require special
accounting treatment for regulated companies to show the effect of regulation.
For example, in setting TEP, UNS Gas and UNS Electric's retail rates, the ACC
may not allow TEP, UNS Gas or UNS Electric to currently charge their customers
to recover certain expenses, but instead may require that these expenses be
charged to customers in the future. In this situation, FAS 71 requires that TEP,
UNS Gas and UNS Electric defer these items and show them as regulatory assets on
the balance sheet until TEP, UNS Gas and UNS Electric are allowed to charge
their customers. TEP, UNS Gas and UNS Electric 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.
CASH AND CASH EQUIVALENTS
UniSource Energy and TEP define Cash and Cash Equivalents as cash
(unrestricted demand deposits) and all highly liquid investments purchased with
an original maturity of three months or less.
UTILITY PLANT
TEP reports its utility plant on its balance sheets at cost. UES reports
the utility plant of its two operating companies, UNS Gas and UNS Electric, at
cost. Utility plant includes:
o Material and labor costs,
o Contractor costs,
o Construction overhead costs (where applicable), and
o An Allowance for Funds Used During Construction (AFUDC) or
capitalized interest during construction.
AFUDC reflects the cost of financing construction for transmission and
distribution projects with borrowed and equity funds.
TEP imputed the cost of capital on transmission and distribution
construction expenditures at an average of 8.67% in 2004, 8.43% in 2003, and
8.40% in 2002, to reflect the cost of using borrowed and equity funds to finance
construction. The component of AFUDC attributable to borrowed funds is included
as a reduction of Other Interest Expense on the income statement and totaled $1
million in 2004, 2003, and 2002. The equity component is included in Other
Income and totaled $1 million in 2004, 2003, and 2002.
K-95
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
The interest capitalized during construction of TEP's generation-related
construction projects is included as a reduction of Other Interest Expense on
the income statement and totaled $1 million in 2004, 2003, and $0.5 million in
2002. The average capitalized interest rate during construction applied to
generation-related construction expenditures was 4.33% in 2004, 4.14% in 2003,
and 4.26% in 2002.
For 2004 and the period August 11, 2003 through December 31, 2003, UES
imputed the cost of capital on construction expenditures at an average of 8.73%
for UNS Electric and 7.85% for UNS Gas. The component of AFUDC attributable to
borrowed funds is included as a reduction of Other Interest Expense on the
income statement and totaled $0.5 million in 2004 and $0.2 million in 2003. The
equity component is included in Other Income and totaled $0.5 million in 2004
and $0.2 million in 2003.
DEPRECIATION
TEP and UES compute depreciation for owned utility plant on a
straight-line basis at rates based on the economic lives of the assets. See Note
9. The depreciation rates are approved by the ACC for all plant except TEP's
deregulated generation assets. The depreciable lives for TEP's generation plant
are based on remaining useful lives. Changes made to the depreciable lives of
TEP's generation plant are discussed in Note 9. The depreciation rates for
generation plant reflect interim retirements. Interim retirements of generation
plant, together with removal costs less salvage, are charged to accumulated
depreciation. The costs of planned major maintenance activities are recorded as
the costs are actually incurred and are not accrued in advance of the planned
maintenance. Planned major maintenance activities include the scheduled
overhauls at TEP's generation plants. Minor replacements and repairs are
expensed as incurred.
The depreciable lives for transmission, distribution, general and
intangible plant are based on average lives. The rates reflect estimated removal
costs, net of estimated salvage value for interim retirements. Retirements of
transmission plant, distribution plant, general plant and intangible plant,
together with the cost of removal less salvage, are charged to accumulated
depreciation. Amounts collected through revenues for the net cost of removal of
interim retirements for transmission, distribution, general and intangible plant
which are not yet expended, are reflected as a regulatory liability.
The average annual depreciation rates for TEP's utility plant were 3.80%
in 2004, 3.78% in 2003, and 4.01% in 2002. The average annual depreciation rates
for UES' utility plant in 2004 were 4.38% for UNS Electric and 2.81% for UNS
Gas. The average annualized depreciation rates for UES' utility plant for the
period of August 11, 2003 through December 31, 2003 were 4.25% for UNS Electric
and 2.67% for UNS Gas.
COMPUTER SOFTWARE COSTS
TEP and UES capitalize all costs incurred to purchase computer software
and amortize those costs over the estimated economic life of the product.
Capitalized computer software costs would be immediately charged to expense if
the software is determined to be no longer useful. TEP's amortization of
capitalized computer software costs was $8 million in 2004 and $6 million in
2003 and 2002.
TEP UTILITY PLANT UNDER CAPITAL LEASES
TEP financed the following generation assets with capital leases:
o Springerville Common Facilities,
o Springerville Unit 1,
o Springerville Coal Handling Facilities, and
o Sundt Unit 4.
The following table shows the amount of lease expense incurred for TEP's
generation-related capital leases. We describe the lease terms in TEP Capital
Lease Obligations in Note 10.
K-96
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
Years Ended December 31,
2004 2003 2002
- --------------------------------------------------------------------------------------------------
-Millions of Dollars-
Lease Expense:
Interest Expense on Capital Leases $ 86 $ 84 $ 88
Amortization - Included in:
Operating Expenses - Fuel 4 4 4
Operating Expenses - Depreciation and Amortization 18 25 25
- --------------------------------------------------------------------------------------------------
Total Lease Expense $ 108 $ 113 $ 117
==================================================================================================
GLOBAL SOLAR PROPERTIES AND EQUIPMENT
Global Solar's properties and equipment are included, net of accumulated
depreciation, in UniSource Energy's balance sheets in the Investments and Other
Property - Other line item. Properties and equipment are stated at original cost
and are depreciated using the straight-line method over the estimated useful
lives of the assets. Maintenance, repairs and minor renewals are charged to
expense as incurred, while major renewals and betterments are capitalized.
EVALUATION OF ASSETS FOR IMPAIRMENT
TEP, UNS Gas and UNS Electric evaluate their Utility Plant and other
long-lived assets for impairment whenever events or circumstances occur that may
indicate the carrying value of the assets may be impaired. If the fair value of
the asset determined based on the undiscounted expected future cash flows from
the long-lived asset is less than the carrying value of the asset, an impairment
would be recorded.
DEBT
We defer costs related to the issuance of debt. These costs include
underwriters' commissions, discounts or premiums, and other costs such as legal,
accounting and regulatory fees and printing costs. We amortize these costs over
the life of the debt using the straight-line method, which approximates the
effective interest method.
TEP recognizes gains and losses on reacquired debt associated with the
generation portion of its operations as incurred. TEP defers and amortizes the
gains and losses on reacquired debt associated with its regulated operations to
interest income or interest expense over the remaining life of the original
debt.
UTILITY OPERATING REVENUES
TEP and UES record utility operating revenues when services are provided
or commodities are delivered to customers. Operating revenues include unbilled
revenues which are earned (service has been provided) but not billed by the end
of an accounting period.
Unbilled sales are estimated for the month by reviewing the meter reading
schedules and determining the number of billed and unbilled kWhs or therms, as
applicable, for each cycle. Current month estimated unbilled kWhs or therms are
allocated by customer class. New unbilled revenue estimates are recorded and
unbilled revenue estimates from the prior month are reversed.
An Allowance for Doubtful Accounts is recorded as an expense and reduces
accounts receivable for revenue amounts that are estimated to become
uncollectible. TEP and UES establish an allowance for doubtful accounts
receivable based on historical experience and any specific customer collection
issues identified. TEP's Allowance for Doubtful Accounts was $14 million at
December 31, 2004 and $11 million at December 31, 2003. See Note 13 for further
discussion of TEP's wholesale accounts receivable and allowances. UES' Allowance
for Doubtful Accounts was $2 million at December 31, 2004 and $0.4 million at
December 31, 2003.
REVENUE FROM LONG-TERM RESEARCH AND DEVELOPMENT CONTRACTS
UniSource Energy's income statement includes Global Solar's long-term
contract revenue in Other Operating Revenues. Global Solar recognized long-term
contract revenue of less than $1 million in 2004 and just over $1 million in
2003 and 2002. Global Solar and IPS recognized total research and development
expense of $5 million in 2004, $7 million in 2003 and $8 million in 2002. These
expenses include both costs associated with revenue producing contracts and
internal development costs. Global Solar derives much of its revenue from
funding received under research and development contracts with various U.S.
governmental agencies. Revenues on these contracts are recognized as follows:
o COST REIMBURSEMENT CONTRACTS - Revenue is recognized as costs are
incurred;
o COST PLUS FIXED FEE CONTRACTS - Revenues are recognized using the
percentage of completion method of accounting by relating
contract costs incurred to date to total contract costs; and
K-97
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
o FIXED FEE CONTRACTS - Revenues are recognized when applicable
milestones are met.
Contract costs include direct material, direct labor and overhead costs.
FUEL AND PURCHASED ENERGY COSTS
TEP
Fuel inventory, primarily coal, is recorded at weighted average cost. TEP
uses full absorption costing. Under full absorption costing, all handling and
procurement costs are included in the cost of the inventory. Examples of these
costs are direct material, direct labor and overhead costs. TEP has long-term
contracts for the purchase and transportation of coal with expiration dates from
2006 through 2020. The contracts require TEP to pay a take-or-pay fee if certain
minimum quantities of coal are not purchased or transported. TEP expenses such
fees as they are incurred. TEP recorded minimal take-or-pay fees in 2004 and
less than $1 million of take-or-pay fees in 2003 and 2002. See Purchase and
Transportation Commitments in Note 8, below. Fuel costs include coal mine
reclamation expenses as they are charged to TEP on an ongoing basis.
UES
UNS Gas defers differences between actual gas purchase costs and the
recovery of such costs in revenues under a Purchased Gas Adjustor (PGA)
mechanism. The PGA mechanism is intended to address the volatility of natural
gas prices and allows UNS Gas to recover its costs through a price adjustor. The
PGA charge may be changed monthly based on an ACC approved mechanism that
compares the twelve-month rolling average gas cost to the base cost of gas,
subject to limitations on how much the price per therm may change in a twelve
month period. The difference between the actual cost of UNS Gas' gas supplies
and transportation contracts and that currently allowed by the ACC is deferred
and recovered or repaid through the PGA mechanism. When under or over recovery
trigger points are met, UNS Gas may request a PGA surcharge or surcredit with
the goal of collecting or returning the amount deferred from or to customers
over a twelve month period. UNS Gas had an asset for under recovered purchased
gas costs of $2 million at December 31, 2004 and $3 million at December 31, 2003
that is included in Current Regulatory Assets on UniSource Energy's consolidated
balance sheet.
UNS Electric defers differences between purchased energy costs and the
recovery of such costs in revenues. Future billings are adjusted for such
deferrals through use of a Purchased Power and Fuel Adjustment Clause (PPFAC)
approved by the ACC. The PPFAC allows for a revenue surcharge or surcredit (that
adjusts the customer's base rate for delivered purchased power) to collect or
return under or over recovery of costs. UNS Electric had a liability for over
recovered purchased power costs of $3 million at December 31, 2004 and less than
$1 million at December 31, 2003 that is included in Deferred Credits and Other
Liabilities - Other on UniSource Energy's consolidated balance sheet. See Note
3.
INCOME TAXES
We are required by GAAP to report some of our assets and liabilities
differently for our financial statements than we do for income tax purposes. The
tax effects of differences in these items are reported as deferred income tax
assets or liabilities in our balance sheets. We measure these tax assets and
liabilities using income tax rates that are currently in effect. Federal
Investment Tax Credits (ITC) as well as applicable state income tax credits are
accounted for as a reduction of income tax expense in the year in which the
credit arises.
We allocate income taxes to the subsidiaries based on their taxable income
and deductions as reported in the consolidated and/or combined tax return
filings.
EMISSIONS ALLOWANCES
Emissions Allowances are issued to qualifying utilities by the
Environmental Protection Agency (EPA) based on past operational history. Each
allowance permits emission of one ton of sulfur dioxide (SO2) in its vintage
year or a subsequent year. TEP receives an allotment of these allowances
annually, but UNS Electric doesn't receive any since it has no coal-fired
generation. When issued from the EPA, these allowances have no book value for
accounting purposes but may be sold if TEP does not need them for operations.
K-98
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
TEP also may purchase additional allowances if needed. See Note 8. In December
2004, TEP sold 4,000 allowances that were in excess of those required for
compliance to a third party at their fair market value of $3 million. In 2002,
TEP also sold 4,000 excess allowances to Millennium Environmental Group, Inc.
(MEG) at their fair market value of less than $1 million. MEG subsequently sold
these allowances to a third party. The gains from these sales of excess
allowances are reflected as a reduction of Other Operations and Maintenance
expense on TEP's income statement. TEP did not sell any excess allowances in
2003.
DERIVATIVE FINANCIAL INSTRUMENTS
TEP enters into forward contracts to purchase or sell a specified amount
of capacity or energy at a specified price over a given period of time,
typically for one month, three months, or one year, within established limits to
take advantage of favorable market opportunities. The majority of TEP's forward
contracts are considered to be normal purchases and sales and, therefore, are
not required to be marked to market. However, some of these forward contracts
are considered to be derivatives, which TEP marks to market by recording
unrealized gains and losses and adjusting the related assets and liabilities on
a monthly basis to reflect the market prices at the end of the month.
TEP also periodically enters into commodity price swap agreements in an
effort to minimize commodity price risk on its spot market purchases of natural
gas. Under these agreements, TEP purchases gas at fixed prices and
simultaneously sells gas at spot market prices. The swap agreements are
accounted for as cash flow hedges by recording the unrealized gains and losses
in Other Comprehensive Income on the balance sheet and adjusting the related
assets and liabilities on a monthly basis to reflect the market prices at the
end of the month. As the gains and losses on these cash flow hedges are
realized, a reclassification adjustment is recorded in Other Comprehensive
Income for realized gains and losses that are included in Net Income. See Note
7.
UNS Gas and UNS Electric do not currently have any contracts that are
required to be marked to market.
MEG enters into swap agreements, options and forward contracts relating to
Emissions Allowances and coal. MEG marks its trading contracts to market by
recording unrealized gains and losses and adjusting the related assets and
liabilities on a monthly basis to reflect the market prices at the end of the
month.
STOCK-BASED COMPENSATION
At December 31, 2004, UniSource Energy had outstanding awards issued under
two stock-based compensation plans, the 1994 Outside Director Stock Option Plan
(Directors' Plan) and the 1994 Omnibus Stock and Incentive Plan (Omnibus Plan).
See Note 17. Through December 31, 2004, we accounted for those plans under the
recognition and measurement principles of APB Opinion No. 25, Accounting for
Stock Issued to Employees (APB 25), as allowed by Statement of Financial
Accounting Standards No. 123, Accounting for Stock-Based Compensation (FAS 123).
However, management early adopted Statement of Financial Accounting Standards
No. 123R, Share Based Payment effective January 1, 2005. See New Accounting
Standards, below.
Our stock options are granted with an exercise price equal to the market
value of the stock at the date of the grant. Accordingly, no compensation
expense is recorded for these awards. However, compensation expense is
recognized for restricted stock, stock unit, and performance share awards over
the performance/vesting period.
The following table illustrates the effect on UniSource Energy's net
income and earnings per share and TEP's net income had we applied the fair value
recognition provisions of FAS 123 and recognized compensation expense for all
stock-based employee compensation awards:
K-99
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
UNISOURCE ENERGY:
- ----------------
Years Ended December 31,
2004 2003 2002
- ----------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
(except per share data)
Net Income - As Reported $ 45,919 $ 113,941 $ 34,928
Add: Stock-based employee compensation expense included in
reported net income, net of related tax effects 1,535 850 486
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards,
net of related tax effects (2,314) (1,840) (1,757)
- ----------------------------------------------------------------------------------------------------------------------
Pro Forma Net Income $ 45,140 $ 112,951 $ 33,657
======================================================================================================================
Earnings per Share:
Basic - As Reported $ 1.34 $ 3.37 $ 1.04
Basic - Pro Forma $ 1.31 $ 3.34 $ 1.00
Diluted - As Reported $ 1.31 $ 3.32 $ 1.02
Diluted - Pro Forma $ 1.29 $ 3.29 $ 0.98
- ----------------------------------------------------------------------------------------------------------------------
TEP:
- ---
Years Ended December 31,
2004 2003 2002
- ----------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Net Income - As Reported $ 46,127 $ 128,913 $ 55,390
Add: Stock-based employee compensation expense included in
reported net income, net of related tax effects
1,355 787 467
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards,
net of related tax effects (2,116) (1,761) (1,725)
- ----------------------------------------------------------------------------------------------------------------------
Pro Forma Net Income $ 45,366 $ 127,939 $ 54,132
======================================================================================================================
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 during 2004. For the options granted during 2003 and 2002, the following
weighted average assumptions were used:
2003 2002
- ------------------------------------------------------------------------------------------
Expected life (years) 5 5
Interest rate 2.78% 1.45%
Volatility 23.38% 23.74%
Dividend yield 3.44% 2.83%
Weighted-average grant-date fair value of options granted
during the period $ 2.92 $ 2.90
- ------------------------------------------------------------------------------------------
NEW ACCOUNTING STANDARDS
The FASB recently issued the following Statements of Financial Accounting
Standards (FAS) and FASB Interpretations (FIN):
o FAS 123(R), Share Based Payment, issued December 2004, requires
all share-based payments to employees, including grants of
employee stock options, to be recognized in the financial
statements based on their grant-date fair values. For public
companies, FAS 123(R) is effective for financial periods
beginning after June 15, 2005. However, management adopted FAS
123(R) effective January 1, 2005. The adoption of FAS 123(R) did
not have a significant impact on our financial statements because
stock options issued under UniSource Energy's Omnibus Plan vested
upon the shareholder vote to approve the proposed acquisition of
UniSource Energy. In addition, the Omnibus Plan expired in
February 2004, and no new stock options can be issued. See Note 2
and Note 17.
o FAS 153, Exchanges of Nonmonetary Assets, issued December 2004,
requires nonmonetary exchanges be accounted for at fair value,
recognizing any gains or losses, if their fair value is
determinable within reasonable limits and the transaction has
commercial substance. A nonmonetary exchange has commercial
substance if future cash flows of the entity are expected to
change significantly as a result of the exchange. FAS 153 is
K-100
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
effective for nonmonetary asset exchange transactions occurring
in fiscal periods beginning after June 15, 2005. The adoption of
FAS 153 is not expected to have a significant impact on our
financial statements.
o FASB Staff Position (FSP) FAS 109-1, Application of FASB Statement No.
109, Accounting for Income Taxes, to the Tax Deduction on Qualified
Production Activities Provided by the American Jobs Creation Act of
2004, issued in December 2004, provides guidance on the application of
FAS 109 to the provision within the American Jobs Creation Act of 2004
that provides a tax deduction, beginning in 2005, on qualified
production activities, including a company's electric generation
activities. Under FSP FAS 109-1, recognition of the tax deduction on
qualified production activities is ordinarily reported in the year it
is earned. We are evaluating the impact on our financial position and
results of operations from the adoption of FSP FAS 109-1.
o FAS 151, Inventory Costs, issued November 2004, is an amendment
of Accounting Research Bulletin (ARB) No. 43, Chapter 4,
Inventory Pricing. FAS 151 clarifies that abnormal amounts of
idle facility expense, freight, handling costs, and wasted
materials (spoilage) should be recognized as current-period
charges. FAS 151 also requires the allocation of fixed production
overheads to inventory based on the normal capacity of the
production facilities. FAS 151 is effective for inventory costs
incurred during fiscal years beginning after June 15, 2005. The
adoption of FAS 151 is not expected to have a significant impact
on our financial statements.
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 have a
significant impact on our financial statements.
See our discussion of FSP 106-2 in Note 16.
In July 2004, the Emerging Issues Task Force (EITF) reached a
consensus on Issue No. 02-14, Whether an Investor Should Apply the Equity Method
of Accounting to Investments Other Than Common Stock (EITF 02-14). EITF 02-14
concludes that an investor that has the ability to exercise significant
influence over the operating and financial policies of an investee should apply
the equity method of accounting only when it has an investment in common stock
or an investment that is in-substance common stock. EITF 02-14 is effective for
reporting periods beginning after September 15, 2004. The adoption of EITF 02-14
did not have a significant impact on our financial statements.
In June 2004, the EITF published Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF
03-1). EITF 03-1 provides application guidance on impairment of securities
accounted for under FAS 115, Accounting for Certain Investments in Debt and
Equity Securities, and cost method investments and requires certain quantitative
and qualitative disclosures for securities that are impaired at the balance
sheet date but for which an other-than-temporary impairment has not been
recognized. The disclosure requirements are effective for reporting periods
ending after December 31, 2003. The FASB issued FSP EITF Issue 03-1-1, Effective
Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments in
September 2004 delaying the effective date of the application guidance on
impairment of securities. The adoption of EITF 03-1 is not expected to have a
significant impact on our financial statements.
In August 2003, the EITF published Issue No. 03-11, Reporting Realized
Gains and Losses on Derivative Instruments That Are Subject to FASB Statement
No. 133, Accounting for Derivative Instruments and Hedging Activities, and Not
"Held for Trading Purposes" as Defined in EITF Issue No. 02-3 (EITF 03-11). EITF
03-11 discusses whether realized gains and losses should be shown gross or net
in the income statement for contracts that are not held for trading purposes, as
defined in EITF 02-3, but are derivatives subject to FAS 133, Accounting for
Derivative Instruments and Hedging Activities. 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 December 31, 2004. See Note 7.
RECLASSIFICATIONS
UniSource Energy and TEP have made reclassifications to the prior year
financial statements and footnotes for comparative purposes. See Note 5 and Note
7. These reclassifications had no effect on Net Income.
K-101
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
NOTE 2. TERMINATION OF PROPOSED ACQUISITION OF UNISOURCE ENERGY
- ----------------------------------------------------------------
On November 21, 2003, UniSource Energy and Saguaro Acquisition Corp., a
Delaware corporation, entered into an acquisition agreement, providing for the
acquisition of all of the common stock of UniSource Energy for $25.25 per share
by an affiliate of Saguaro Utility Group L.P., an Arizona limited partnership
(Saguaro Utility), whose general partner is Sage Mountain, L.L.C. and whose
limited partners include investment funds affiliated with Kohlberg Kravis
Roberts & Co., L.P., J.P. Morgan Partners, LLC and Wachovia Capital Partners.
On December 21, 2004, the ACC voted, at the end of a special meeting,
not to approve the application seeking its approval of the proposed acquisition.
On December 30, 2004, Saguaro Utility exercised its right to terminate the
acquisition agreement, and UniSource Energy paid Saguaro Utility $7 million to
cover Saguaro Utility's expenses, pursuant to the terms of the acquisition
agreement. This termination fee, which was expensed as incurred, is included in
Other Operations and Maintenance expense in UniSource Energy and TEP's
Statements of Income and in Other Cash Payments in UniSource Energy and TEP's
Statements of Cash Flows. UniSource Energy allocated $5 million of this
termination fee to TEP with the balance allocated to UNS Gas, UNS Electric, and
Millennium.
UniSource Energy 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.
UniSource Energy expensed $3 million in fees upon announcement of the
transaction in November 2003, which are included in Other Operations and
Maintenance Expense in UniSource Energy's Statements of Income.
LITIGATION CONCERNING THE PROPOSED ACQUISITION AGREEMENT
On August 26, 2004, the Pennsylvania Avenue Event Driven Fund filed a
class action complaint in the Superior Court of the State of Arizona on behalf
of the holders of UniSource Energy Common Stock against UniSource Energy and its
directors (Pennsylvania Ave. Event Driven Fund v. UniSource Energy Corp., et al.
(D. Ariz.)) relating to the proposed acquisition of UniSource Energy by an
affiliate of Saguaro Utility. The plaintiff alleged, among other things, that
members of UniSource Energy's board of directors breached their fiduciary duties
to UniSource Energy's shareholders in connection with the proposed acquisition
by tailoring the acquisition to meet the specific needs of Saguaro Utility and
basing the acquisition on financial results of UniSource Energy that were
subsequently restated to recognize additional net income. The court dismissed
the action in February 2005.
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.
NOTE 3. UNISOURCE ENERGY SERVICES
- ----------------------------------
On August 11, 2003, UniSource Energy acquired the Arizona gas and electric
system assets from Citizens for $223 million, comprised of the base purchase
price plus other operating capital adjustments and transaction costs. This
acquisition added over 132,000 retail gas customers and 85,000 retail electric
customers in Arizona to UniSource Energy's customer base as of December 31,
2004. UniSource Energy formed UNS Gas, Inc. (UNS Gas) and UNS Electric, Inc.
(UNS Electric) to acquire these assets, as well as, 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.
The purchase price and the final allocation of the assets acquired and the
liabilities assumed based on their estimated fair market values as of the
acquisition date are as follows:
K-102
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
PURCHASE PRICE: -Thousands of Dollars-
----------------------------------------------------------------------
Cash Paid $ 218,558
Transaction Costs 4,838
----------------------------------------------------------------------
TOTAL PURCHASE PRICE $ 223,396
======================================================================
ALLOCATION OF PURCHASE PRICE: -Thousands of Dollars-
----------------------------------------------------------------------
Property, Plant & Equipment $ 229,703
Current Assets 31,377
Regulatory Assets 384
Other Assets 580
Long-Term Debt (1,119)
Current Liabilities (31,176)
Deferred Credits and Other Liabilities (6,353)
----------------------------------------------------------------------
TOTAL PURCHASE PRICE $ 223,396
======================================================================
RATES AND REGULATION
Concurrent with the closing of the acquisition, retail rate increases for
customers of both UNS Electric and UNS Gas went into effect on August 11, 2003.
These rate increases were approved by the ACC on July 3, 2003, when it approved
the acquisition and the terms of the April 1, 2003 settlement agreement (UES
Settlement Agreement) among UniSource Energy, Citizens, and the ACC Staff.
UNS GAS
UNS Gas is regulated by the ACC with respect to retail gas rates, the
issuance of securities, and transactions with affiliated parties. UNS Gas'
retail gas rates include a monthly customer charge, a base rate charge for
delivery services and the cost of gas (expressed in cents per therm), and a PGA
mechanism.
The related ACC order and the UES Settlement Agreement include the
following terms related to UNS Gas rates:
o An increase in retail delivery base rates, effective August 11,
2003, equivalent to a 20.9% overall increase over 2001 test year
retail revenues through a base rate increase.
o Fair value rate base of $142 million and allowed rate of return
of 7.49%, based on a cost of capital of 9.05%, derived from a
cost of equity of 11.00% and a cost of debt of 7.75% (based on a
capital structure of 60% debt and 40% equity).
o The existing PGA rate may not change more than $0.15 per therm
through July 2004. Thereafter, the PGA rate may not change more
than $0.10 per therm.
Under the terms of the ACC order, UNS Gas may not file a general rate
increase until August 2006 and any resulting rate increase shall not become
effective prior to August 1, 2007.
The UES Settlement Agreement also limits dividends payable by UNS Gas to
UniSource Energy to 75% of earnings until the ratio of common equity to total
capitalization reaches 40%. The ratio of common equity to total capitalization
for UNS Gas is 37% at December 31, 2004.
In January 2005, UNS Gas requested the ACC approve a PGA surcharge of
$0.06 per therm beginning April 1, 2005 and removed one year later, to recover
its excess gas purchase costs. At December 31, 2004, the PGA bank balance was $9
million. The previous PGA surcharge of $0.1155 per therm took effect October 1,
2003 and ended November 1, 2004.
UNS ELECTRIC
UNS Electric is regulated by the ACC with respect to retail electric
rates, the issuance of securities, and transactions with affiliated parties, and
by the FERC with respect to wholesale power contracts and interstate
transmission service.
K-103
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
The ACC order and UES Settlement Agreement include the following terms
related to UNS Electric rates:
o A 22% overall increase in retail rates effective August 11, 2003
from the rates previously in effect for Citizens. This reflects
the implementation of a PPFAC of $0.01825 per kWh, which combined
with the current base purchased power rate of $0.05194 per kWh,
results in a new PPFAC rate of $0.07019. This allows UNS Electric
to fully recover the cost of purchased power under its current
contract with its sole energy supplier, Pinnacle West Capital
Corporation (PWCC).
o UNS Electric must attempt to renegotiate the PWCC purchase power
contract, and any savings that result from a renegotiated
contract must be allocated in a ratio of 90% to ratepayers and
10% to shareholders.
Under the terms of the ACC order, UNS Electric may not file a general rate
increase until August 2006 and any resulting rate increase shall not become
effective prior to August 1, 2007.
The UES Settlement Agreement also limits dividends payable by UNS Electric
to UniSource Energy to 75% of earnings until the ratio of common equity to total
capitalization reaches 40%. The ratio of common equity to total capitalization
for UNS Electric was 40% at December 31, 2004.
INCOME STATEMENT IMPACT OF APPLYING FAS 71
If UES had not applied FAS 71, net income would have been $4 million
greater in 2004 and $2 million higher in 2003, primarily as a result of the
recovery of deferred purchased power and gas costs.
FUTURE IMPLICATIONS OF DISCONTINUING APPLICATION OF FAS 71
UES' regulatory liabilities exceed its regulatory assets by $4 million at
December 31, 2004. At December 31, 2003, UES' regulatory assets, net of
regulatory liabilities, totaled $1 million. UNS Gas and UNS Electric's
regulatory assets and liabilities are included in rate base and consequently are
earning a return on investment. If UES stopped applying FAS 71 to its regulated
operations, it would write off the related balances of its regulatory assets as
an expense and would write off its regulatory liabilities as income on its
income statement. Based on the regulatory asset and liability balances, if UES
had stopped applying FAS 71 to its regulated operations, it would have recorded
an extraordinary after-tax gain of $2 million at December 31, 2004. 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.
UES COMMITMENTS
UNS Gas has firm transportation agreements with El Paso Natural Gas (EPNG)
and Transwestern Pipeline Company (Transwestern) with combined capacity
sufficient to meet its load requirements. The EPNG and Transwestern contracts
expire in August 2011 and January 2007, respectively. EPNG provides gas
transportation service under a converted full requirements contract in which UNS
Gas pays a fixed reservation charge. In July 2003, FERC required the conversion
of UNS Gas' full requirements status under the EPNG agreement to contract demand
starting on September 1, 2003. Upon conversion to contract demand status, UNS
Gas now has specific volume limits in each month and specific receipt point
rights from the available supply basins (San Juan and Permian). These changes
will reduce the amount of less expensive San Juan gas available to UNS Gas. The
impact, however, is not expected to be material. The annual cost of the EPNG
capacity after conversion to contract demand will not change through 2005
(pending a 2006 EPNG rate case after which the rates are expected to increase).
UNS Gas made payments under these contracts of $7 million in 2004 and $2 million
from August 11, 2003 through December 31, 2003.
UNS Electric imports the power it purchases over the Western Area Power
Administration's (WAPA) transmission lines. UNS Electric's transmission capacity
agreements with WAPA provide for annual rate adjustments and expire in February
2008 and June 2011. The contract that expires in 2008 also contains a capacity
adjustment clause. UNS Electric made payments under these contracts of $6
million in 2004 and $2 million from August 11, 2003 through December 31, 2003.
K-104
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
At December 31, 2004, UES estimates its future minimum payments under
these contracts to be:
MINIMUM
PURCHASE
OBLIGATIONS
--------------------------------------
-Millions of Dollars-
2005 $ 14
2006 13
2007 10
2008 5
2009 5
-------------------------------------
Total 2005 - 2009 47
Thereafter 7
-------------------------------------
Total $ 54
=====================================
See Note 10 for a description of UES' long-term debt.
UES SUBSEQUENT EVENTS
In January 2005, UNS Gas established a short-term inter-company promissory
note to UniSource Energy, by which it may borrow up to $10 million for general
corporate purposes. This note bears an interest rate of LIBOR plus 2.50% and
expires January 16, 2006. In March 2005, UniSource Energy contributed an
additional $6 million in equity to UNS Gas and an additional $4 million in
equity to UNS Electric, and UNS Gas repaid the $6 million outstanding on this
note from the proceeds of the $6 million equity contribution.
NOTE 4. TEP REGULATORY MATTERS
- -------------------------------
Upon approval of the TEP Settlement Agreement in November 1999, TEP
discontinued regulatory accounting under FAS 71 for its generation operations.
TEP continues to report its transmission and distribution operations under FAS
71.
TEP SETTLEMENT AGREEMENT
In November 1999, the ACC approved the TEP Settlement Agreement between
TEP and certain customer groups relating to recovery of TEP's transition costs
and standard retail rates. The TEP Settlement Agreement included:
o Consumer choice: By January 1, 2001, consumer choice for energy
supply was available to all customers.
o No rate increase: TEP's retail rates may not be increased until
December 31, 2008. TEP expects to recover the costs of
transmission and distribution under regulated unbundled rates
both during and after this period.
o Recovery of transition costs: TEP's rates include Fixed and
Floating Competition Transition Charge (CTC) components
designated for the recovery of transition costs, including
generation-related regulatory assets and a portion of TEP's
generation plant assets. Retail rates will decrease by the Fixed
CTC amount after TEP has recovered $450 million or on December
31, 2008, whichever occurs first. The Floating CTC equals retail
rates less the price of retail electric service. The price of
retail electric service includes TEP's transmission and
distribution charge and a market energy component based on a
market index for electric energy. Because TEP's total retail
rates are effectively frozen, the Floating CTC is expected to
allow TEP to recoup the balance of transition recovery assets not
otherwise recovered through the Fixed CTC. The Floating CTC will
end no later than December 31, 2008.
o General rate information: TEP was required to file general rate
information by June 1, 2004, including an updated cost-of-service
study. See Recent Regulatory Action, below.
K-105
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
RECENT COURT ACTION
In January 2005, an Arizona Court of Appeals decision became final in
which the Court held invalid certain portions of the ACC rules on retail
competition and related market pricing. Based on this decision, we cannot
predict what changes, if any, the ACC will make to the Rules and how this
decision might ultimately impact our Settlement Agreement.
2004 GENERAL RATE CASE INFORMATION
On June 1, 2004, as required by the Settlement Agreement, TEP filed
general rate case information with the ACC. TEP's filing does not propose any
change in retail rates, and under the terms of the Settlement Agreement, no rate
case filed by TEP through 2008 may result in a net rate increase. However,
absent the restriction on raising rates, TEP believes that the data in it's
filing would justify an increase in retail rates of 16%.
The general rate case information uses a historical test year ended
December 31, 2003 and establishes, based on TEP's standard offer service, that
TEP is experiencing a revenue deficiency of $111 million. The rate case
information includes, among other things, Springerville Unit 1 costs and other
generation costs including fuel costs in excess of those recovered through
existing rates. The proposed weighted cost of capital for the test year ended
December 31, 2003 is 8.78%, including an 11.5% return on equity (increased from
10.67% currently authorized). The rate case information uses a hypothetical 40%
equity capitalization (excluding capital lease obligations) rather than the
hypothetical 37.5% equity capitalization used in TEP's last general rate case.
TEP's actual equity capitalization (excluding capital lease obligations) at
December 31, 2004 was 27%. In the first half of 2005, TEP expects to increase
common equity to 40% of capitalization (excluding capital lease obligations).
Despite the indicated revenue deficiency, the ACC could conclude that TEP should
decrease rates after June 1, 2005; any such determination would be strongly
opposed by TEP.
A procedural order was issued in February 2005 that outlined how the
review of TEP's general rate case information will proceed. The schedule calls
for staff and intervenor testimony to be filed by June 13, 2005 and hearings, as
appropriate, before the administrative law judge to begin September 12, 2005.
K-106
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
TRANSITION RECOVERY ASSET
TEP's Transition Recovery Asset consists of generation-related regulatory
assets and a portion of TEP's generation plant asset costs. Transition costs
being recovered through the Fixed CTC include: (1) the Transition Recovery
Asset; (2) generation-related plant assets included in Plant in Service on the
balance sheet; and (3) excess capacity deferrals related to operating and
capital costs associated with Springerville Unit 2 which were amortized as an
off-balance sheet regulatory asset through 2003. These transition costs were
amortized as follows:
Years Ended December 31,
2004 2003 2002
- ---------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
AMORTIZATION OF TRANSITION COSTS BEING RECOVERED THROUGH THE FIXED CTC:
Transition Costs Being Recovered through the Fixed CTC, beginning of year $ 302 $ 348 $ 384
Amortization of Transition Recovery Asset Recorded on the Income Statement (50) (32) (24)
Amortization of Generation-Related Plant Assets (5) (5) (3)
Amortization of Excess Capacity Deferrals (off-balance sheet) - (9) (9)
- ---------------------------------------------------------------------------------------------------------------------
TRANSITION COSTS BEING RECOVERED THROUGH THE FIXED CTC, END OF YEAR $ 247 $ 302 $ 348
=====================================================================================================================
The portion of the Transition Recovery Asset that is recorded on the
balance sheet was amortized as follows:
Years Ended December 31,
2004 2003 2002
----------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
AMORTIZATION OF TRANSITION RECOVERY ASSET RECORDED ON THE BALANCE SHEET:
Transition Recovery Asset, beginning of year $ 274 $ 306 $ 330
Amortization of Transition Recovery Asset Recorded on the Income Statement (50) (32) (24)
----------------------------------------------------------------------------------------------------------------
TRANSITION RECOVERY ASSET, END OF YEAR $ 224 $ 274 $ 306
================================================================================================================
The remaining transition costs being recovered through the Fixed CTC
differ from the Transition Recovery Asset recorded on the balance sheet as
follows:
December 31,
2004 2003
- --------------------------------------------------------------------------------------------------
-Millions of Dollars-
Transition Costs Being Recovered through the Fixed CTC, end of year $ 247 $ 302
Unamortized Generation-Related Plant Assets (23) (28)
- --------------------------------------------------------------------------------------------------
TRANSITION RECOVERY ASSET, END OF YEAR $ 224 $ 274
==================================================================================================
The remaining Transition Recovery Asset balance will be amortized as costs
are recovered through rates until TEP has recovered $450 million of transition
costs or until December 31, 2008, whichever occurs first.
OTHER REGULATORY ASSETS AND LIABILITIES
In addition to the Transition Recovery Asset related to TEP's generation
assets, the following regulatory assets and liabilities are being recovered
through TEP's transmission and distribution businesses:
K-107
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
December 31,
2004 2003
- --------------------------------------------------------------------------------
-Millions of Dollars-
OTHER REGULATORY ASSETS
Income Taxes Recoverable through Future Revenues $ 45 $ 50
Current Regulatory Assets 10 9
Other Regulatory Assets 14 12
- --------------------------------------------------------------------------------
TOTAL REGULATORY ASSETS $ 69 $ 71
================================================================================
OTHER REGULATORY LIABILITIES
Net Cost of Removal for Interim Retirements $ 67 $ 60
================================================================================
Regulatory assets of approximately $23 million are not presently included
in rate base and consequently are not earning a return on investment. These
regulatory assets are being recovered through cost of service or are authorized
to be collected in future base rates. Current regulatory assets of $10 million
are related to differences between expenses recorded on the accrual basis for
GAAP accounting and on a pay-as-you-go basis for regulatory accounting. The
remaining recovery period generally ranges from 1 to 1.5 years. Regulatory
compliance costs of $11 million require specific rate action and the recovery
period will be determined in the 2004 rate information filing with the ACC. The
remaining $3 million represents unamortized loss on reacquired debt that is not
included in rate base, but the amortization of these costs is included in the
ratemaking calculation of the cost of debt, which is a component of the cost of
capital (rate of return). All regulatory assets are probable of recovery.
See Note 5 for a discussion of the amounts included in Other Regulatory
Liabilities.
INCOME STATEMENT IMPACT OF APPLYING FAS 71
The amortization of TEP's regulatory assets had the following effect on
UniSource Energy's and TEP's income statements:
Years Ended December 31,
2004 2003 2002
- -----------------------------------------------------------------------------------
-Millions of Dollars-
OPERATING EXPENSES
Amortization of Transition Recovery Asset $ 50 $ 32 $ 24
INTEREST EXPENSE
Long-Term Debt - - 1
INCOME TAXES 5 7 7
- -----------------------------------------------------------------------------------
TOTAL $ 55 $ 39 $ 32
===================================================================================
If TEP had not applied FAS 71 in these years, the above amounts would have
been reflected in the income statements in prior periods. The reclassification
of TEP's generation-related regulatory assets to the Transition Recovery Asset
shortened the amortization period for these assets to nine years.
FUTURE IMPLICATIONS OF DISCONTINUING APPLICATION OF FAS 71
TEP continues to apply FAS 71 to its regulated operations, which include
the transmission and distribution portions of its business. TEP regularly
assesses whether it can continue to apply FAS 71 to these operations. If TEP
stopped applying FAS 71 to its remaining regulated operations, it would write
off the related balances of its regulatory assets as an expense and its
regulatory liabilities as income on its income statement. Based on the
regulatory asset balances, net of regulatory liabilities, at December 31, 2004,
if TEP had stopped applying FAS 71 to its remaining regulated operations, it
would have recorded an extraordinary after-tax loss of approximately $136
million. While regulatory orders and market conditions may affect cash flows,
K-108
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
TEP's cash flows would not be affected if it stopped applying FAS 71 unless a
regulatory order limited its ability to recover the cost of its regulatory
assets.
NOTE 5. ACCOUNTING CHANGE: ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS
- ------------------------------------------------------------------------
In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 143, Accounting for Asset
Retirement Obligations (FAS 143). It requires entities to record the fair value
of a liability for a legal obligation to retire an asset in the period in which
the liability is incurred. A legal obligation is a liability that a party is
required to settle as a result of an existing or enacted law, statute, ordinance
or contract. When the liability is initially recorded, the entity should
capitalize a cost by increasing the carrying amount of the related long-lived
asset. Over time, the liability is adjusted to its present value by recognizing
accretion expense as an operating expense in the income statement each period,
and the capitalized cost is depreciated over the useful life of the related
asset. Upon settlement of the liability, an entity either settles the obligation
for its recorded amount or incurs a gain or loss if the actual costs differ from
the recorded amount.
Prior to adopting FAS 143, costs for final removal of all owned generation
facilities were accrued as an additional component of depreciation expense.
Under FAS 143, only the costs to remove an asset with legally binding retirement
obligations will be accrued over time through accretion of the asset retirement
obligation and depreciation of the capitalized asset retirement cost.
TEP has identified legal obligations to retire generation plant assets
specified in land leases for its jointly-owned Navajo and Four Corners
Generating Stations. The land on which these stations reside is leased from the
Navajo Nation. The provisions of the leases require the lessees to remove the
facilities upon request of the Navajo Nation at the expiration of the leases.
TEP also has certain environmental obligations at the San Juan Generating
Station (San Juan). TEP has estimated that its share of the cost to remove the
Navajo and Four Corners facilities and to settle the San Juan environmental
obligations will be approximately $38 million at the date of retirement. No
other legal obligations to retire generation plant assets were identified. As of
December 31, 2002, TEP had accrued $113 million for the final decommissioning of
its generating facilities. As discussed below, this amount was reversed for 2002
and included as part of the cumulative effect of accounting change adjustment
when FAS 143 was adopted on January 1, 2003.
On November 12, 2004, TEP, Phelps Dodge Energy Services, LLC and PNM
Resources, Inc. each purchased from Duke Energy North America, LLC a one-third
interest in a limited liability company which owns the partially constructed
natural gas-fired Luna Energy Facility (Luna) in southern New Mexico. Luna is
designed as a 570-MW combined cycle plant and is expected to be operational by
the summer of 2006. The new owners assumed asset retirement obligations to
remove certain piping and evaporation ponds and to restore the ground to its
original condition. TEP has estimated its share to settle the obligations will
be approximately $2 million at the date of retirement.
TEP and UES have various transmission and distribution lines that operate
under land leases and rights of way that contain end dates and restorative
clauses. TEP and UES operate their transmission and distribution systems as if
they will be operated in perpetuity and would continue to be used or sold
without land remediation. As a result, TEP and UES are not recognizing the costs
of final removal of the transmission and distribution lines in their financial
statements. As of December 31, 2004, TEP had accrued $67 million and UES had
accrued $2 million for the net cost of removal for interim retirements from its
transmission, distribution and general plant. As of December 31, 2003, TEP had
accrued $60 million and UES had accrued $0.6 million for these removal costs.
These amounts are reflected in the financial statements 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 $1.1 million,
increased depreciable assets by $0.1 million for asset retirement costs,
reversed $112.8 million of costs previously accrued for final removal from
accumulated depreciation, reversed previously recorded deferred tax assets of
$44.2 million and recognized the cumulative effect of accounting change as a
gain of $111.7 million ($67.5 million net of tax). The adoption of FAS 143 also
resulted in a $6 million reduction of current depreciation expense charged
throughout the year because asset retirement costs are no longer recorded as a
component of depreciation expense.
K-109
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
The following table illustrates on a pro forma basis the amount of the
asset retirement obligation as if FAS 143 had been applied during all periods
presented:
Years Ended December 31,
2004 2003 2002
ACTUAL ACTUAL Pro Forma
- ----------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Asset Retirement Obligation, beginning of year $ 1,231 $ 1,119 $ 1,017
Accretion Expense 146 112 102
- ----------------------------------------------------------------------------------------------------------------------
ASSET RETIREMENT OBLIGATION, END OF YEAR $ 1,377 $ 1,231 $ 1,119
======================================================================================================================
The following tables illustrate on a pro forma basis the effect on
UniSource Energy's net income and earnings per share and TEP's net income as if
FAS 143 had been in effect for all income statement periods presented:
UNISOURCE ENERGY:
- ----------------
Year Ended
December 31, 2002
- ----------------------------------------------------------------------------------------------
-Thousands of Dollars-
(except per share data)
Net Income - As Reported $ 34,928
Adjustment to accrued expense (net of tax) as if FAS 143
had been applied effective January 1, 2002 3,461
- ----------------------------------------------------------------------------------------------
PRO FORMA NET INCOME $ 38,389
==============================================================================================
Basic Earnings per Share:
As Reported $ 1.04
Adjustment to accrued expense (net of tax) as if FAS 143
had been applied effective January 1, 2002 0.10
- ----------------------------------------------------------------------------------------------
PRO FORMA $ 1.14
==============================================================================================
Diluted Earnings per Share:
As Reported $ 1.02
Adjustment to accrued expense (net of tax) as if FAS 143
had been applied effective January 1, 2002 0.10
- ----------------------------------------------------------------------------------------------
PRO FORMA $ 1.12
==============================================================================================
TEP:
- ---
Year Ended
December 31, 2002
- ----------------------------------------------------------------------------------------------
-Thousands of Dollars-
Net Income - As Reported $ 55,390
Adjustment to accrued expense (net of tax) as if FAS 143
had been applied effective January 1, 2002 3,461
- ----------------------------------------------------------------------------------------------
PRO FORMA NET INCOME $ 58,851
==============================================================================================
Amounts recorded under FAS 143 are subject to various assumptions and
determinations, such as determining whether a legal obligation exists to remove
assets, estimating the fair value of the costs of removal, estimating when final
removal will occur, and the credit-adjusted risk-free interest rates to be used
to discount future liabilities. Changes that may arise over time with regard to
these assumptions and determinations will change amounts recorded in the future
as expense for asset retirement obligations.
K-110
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
If TEP retires any asset at the end of its useful life, without a legal
obligation to do so, it will record retirement costs at that time as incurred or
accrued. TEP does not believe that the adoption of FAS 143 will result in any
change in retail rates since all matters relating to the rate-making treatment
of TEP's generating assets were determined pursuant to the TEP Settlement
Agreement.
NOTE 6. SEGMENT AND RELATED INFORMATION
- ----------------------------------------
Based on the way we organize our operations and evaluate performance, we
have four reportable segments:
(1) TEP, a vertically integrated electric utility business, is
UniSource Energy's largest subsidiary.
(2) UNS Gas is a regulated gas distribution business. Results from
UNS Gas are for the period from August 11, 2003 through December
31, 2004 only (see Notes 1 and 3).
(3) UNS Electric is a regulated electric distribution utility
business. Results from UNS Electric are also for the period from
August 11, 2003 through December 31, 2004 only (see Notes 1 and
3).
(4) Global Solar, a developer and manufacturer of light-weight
thin-film photovoltaic cells and panels, is the largest
investment held by Millennium.
The UniSource Energy, UES and Millennium holding companies, UED, and
several other subsidiaries and equity investments, which are not considered
reportable segments, are included in All Other. Through affiliates, Millennium
holds investments in several unregulated energy and emerging technology
companies. UED, a wholly-owned subsidiary of UniSource Energy, developed
generating resources and performed other project development activities,
including the expansion of the Springerville Generating Station.
Significant revenues and expenses included in All Other include the
following:
o In 2004, Millennium recorded its share of income and losses
related to gains and losses on sales of investments by its
investees.
o In 2004, UED recognized an impairment loss on the entire $2
million balance of a note receivable.
o In 2003, UED received a development fee (including accrued
interest on development funds advanced) of $11 million in
connection with expansion of the Springerville Generating
Station. See Note 14.
Our reportable segments have changed from the segments reported in prior
years. We have reclassified information for earlier periods to conform to the
current year's presentation.
Significant reconciling adjustments consist of the elimination of
intercompany activity and balances. Global Solar recorded revenue from
transactions with TEP of $4 million, $8 million and $7 million in 2004, 2003 and
2002, respectively. Millennium's other subsidiaries also recorded revenue from
transactions with TEP of $13 million, $8 million and $8 million in 2004, 2003
and 2002, respectively. TEP's related expense is reported in Other Operations
and Maintenance expense on its income statement. Global Solar's and Millennium's
revenue and TEP's related expense are eliminated in UniSource Energy
consolidation. Other significant reconciling adjustments include the elimination
of investments in subsidiaries held by UniSource Energy, the intercompany note
between UniSource Energy and TEP, the related interest income and expense on the
note, reclassifications of deferred tax assets and liabilities, and the
elimination of UED's rental income and TEP's rental expense resulting from UED's
turbine lease to TEP prior to UED's sale of the turbine to TEP in September
2002.
As discussed in Note 1, we record our percentage share of the earnings of
affiliated companies when we hold a 20% to 50% voting interest, except for
investments where we provide all of the financing, in which case we recognize
100% of the losses. Our portion of the net income (loss) of the entities in
which TEP and Millennium own a 20-50% interest or have the ability to exercise
significant influence is shown below in Net Income (Loss) from Equity Method
Entities.
K-111
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
We disclose selected financial data for our reportable segments in the
following tables:
REPORTABLE SEGMENTS
------------------------------------ UNISOURCE
UNS UNS GLOBAL ALL RECONCILING ENERGY
2004 TEP GAS ELECTRIC SOLAR OTHER ADJUSTMENTS CONSOLIDATED
- ----------------------------------------------------------------------------------------------------------------------------------
INCOME STATEMENT -Millions of Dollars-
- ----------------
Operating Revenues - External $ 887 $ 129 $ 144 $ 5 $ 4 $ - $ 1,169
Operating Revenues - Intersegment 2 - - 4 14 (20) -
Depreciation and Amortization 117 5 9 3 1 - 135
Amortization of Transition Recovery
Asset 50 - - - - - 50
Interest Income 29 - - - - (9) 20
Net Income from Equity Method Entities - - - - 6 - 6
Interest Expense 157 6 5 - 9 (9) 168
Income Tax Expense (Benefit) 35 4 3 (4) (4) - 34
Net Income (Loss) 46 6 4 (5) (5) - 46
- ----------------------------------------------------------------------------------------------------------------------------------
CASH FLOW STATEMENT
-------------------
Net Cash Flows - Operating Activities 275 21 19 (10) 7 (5) 307
Net Cash Flows - Investing Activities -
Capital Expenditures (116) (19) (19) - - 1 (153)
Net Cash Flows - Investing Activities -
Investments in and Loans to Equity
Method Entities - - - - (4) - (4)
Net Cash Flows - Investing Activities -
Other (10) - - - 11 - 1
Net Cash Flows - Financing Activities (101) (1) (2) 9 (7) 4 (98)
- ----------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET
-------------
Total Assets 2,742 201 135 20 930 (852) 3,176
Investments in Equity Method Entities 2 - - - 34 - 36
- ----------------------------------------------------------------------------------------------------------------------------------
2003
- ----------------------------------------------------------------------------------------------------------------------------------
INCOME STATEMENT
----------------
Operating Revenues - External $ 851 $ 47 $ 56 $ 2 $ 17 $ - $ 973
Operating Revenues - Intersegment 1 - - 8 9 (18) -
Depreciation and Amortization 121 2 3 3 2 - 131
Amortization of Transition Recovery
Asset 32 - - - - - 32
Interest Income 31 - - - - (11) 20
Net Loss from Equity Method Entities - - - - (3) - (3)
Interest Expense 161 2 2 1 12 (11) 167
Income Tax Expense (Benefit) 21 1 1 (5) (6) - 12
Net Income (Loss) 129 1 2 (7) (11) - 114
- ----------------------------------------------------------------------------------------------------------------------------------
CASH FLOW STATEMENT
-------------------
Net Cash Flows - Operating Activities 261 5 8 (13) 2 - 263
Net Cash Flows - Investing Activities -
Capital Expenditures (122) (9) (5) (2) 1 - (137)
Net Cash Flows - Investing Activities -
Investments in and Loans to Equity
Method Entities - - - - (2) - (2)
Net Cash Flows - Investing Activities -
Other 11 (137) (84) - (2) - (212)
Net Cash Flows - Financing Activities (141) 149 93 16 (19) - 98
- ----------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET
-------------
Total Assets 2,767 185 125 26 845 (825) 3,123
Investments in Equity Method Entities 5 - - - 31 - 36
- ----------------------------------------------------------------------------------------------------------------------------------
K-112
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------------
2002
- ----------------------------------------------------------------------------------------------------------------------------------
INCOME STATEMENT
----------------
Operating Revenues - External $ 834 $ - $ - $ 1 $ 5 $ - $ 840
Operating Revenues - Intersegment - - - 7 10 (17) -
Depreciation and Amortization 124 - - 3 1 - 128
Amortization of Transition Recovery
Asset 24 - - - - - 24
Interest Income 29 - - - 1 (9) 21
Net Loss from Equity Method Entities (1) - - - (3) - (4)
Interest Expense 154 - - - 10 (9) 155
Income Tax Expense (Benefit) 36 - - (1) (17) - 18
Net Income (Loss) 55 - - (14) (6) - 35
- ----------------------------------------------------------------------------------------------------------------------------------
CASH FLOW STATEMENT
-------------------
Net Cash Flows - Operating Activities 207 - - (10) (21) - 176
Net Cash Flows - Investing Activities -
Capital Expenditures (103) - - (9) (1) - (113)
Net Cash Flows - Investing Activities -
Purchase of North Loop Gas Turbine
from UED (15) - - - 15 - -
Net Cash Flows - Investing Activities -
Investments in and Loans to Equity
Method Entities - - - - (24) - (24)
Net Cash Flows - Investing Activities -
Other (136) - - - 1 - (135)
Net Cash Flows - Financing Activities (57) - - 18 (4) - (43)
- ----------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET
-------------
Total Assets 2,809 - - 22 797 (742) 2,886
Investments in Equity Method Entities 6 - - - 35 - 41
- ----------------------------------------------------------------------------------------------------------------------------------
NOTE 7. ACCOUNTING FOR DERIVATIVE INSTRUMENTS, TRADING ACTIVITIES AND HEDGING
- ------------------------------------------------------------------------------
ACTIVITIES
- ----------
TEP enters into forward contracts to purchase or sell a specified amount
of capacity or energy at a specified price over a given period of time,
typically for one month, three months, or one year, within established limits to
take advantage of favorable market opportunities. In general, TEP enters into
forward purchase contracts when market conditions provide the opportunity to
purchase energy for its load at prices that are below the marginal cost of its
supply resources or to supplement its own resources (e.g., during plant outages
and summer peaking periods). TEP enters into forward sales contracts when it
forecasts that it has excess supply and the market price of energy exceeds its
marginal cost. The majority of TEP's forward contracts are considered to be
normal purchases and sales and, therefore, are not required to be marked to
market. However, some of these forward contracts are considered to be
derivatives, which TEP marks to market by recording unrealized gains and losses
and adjusting the related assets and liabilities on a monthly basis to reflect
the market prices at the end of the month.
TEP 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. During 2004 and early 2005, 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 expire during the summer months through
2007, 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 entered into in 2004 are accounted
for as cash flow hedges in the financial statements as of December 31, 2004.
TEP's 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
K-113
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
component of Common Stock Equity, rather than being reflected in the income
statement. As the gains and losses on these cash flow hedges are realized, a
reclassification adjustment is recorded in Other Comprehensive Income for
realized gains and losses that are included in Net Income. At December 31, 2003,
TEP had no such material cash flow hedges.
TEP manages the risk of counterparty default by performing financial
credit reviews, setting limits, monitoring exposures, requiring collateral when
needed, and using a standardized agreement which allows for the netting of
current period exposures to and from a single counterparty.
UNS Gas and UNS Electric do not currently have any contracts that are
required to be marked to market. UNS Gas does have a natural gas supply and
management agreement under which it purchases substantially all of its gas
requirements at market prices from BP Energy Company (BP). However, the contract
terms allow UNS Gas to lock in fixed prices on a portion of its gas purchases by
entering into fixed price forward contracts with BP at various times during the
year. This enables UNS Gas to provide more stable prices to its customers. These
purchases are made up to three years in advance with the goal of locking in
fixed prices on at least 45% and not more than 80% of the expected monthly gas
consumption prior to entering into the month. These forward contracts, as well
as the main gas supply contract, meet the definition of normal purchases and
therefore are not required to be marked to market.
MEG, a wholly-owned subsidiary of Millennium, enters into swap agreements,
options and forward contracts relating to Emissions Allowances and coal. MEG
marks its trading contracts to market by recording unrealized gains and losses
and adjusting the related assets and liabilities on a monthly basis to reflect
the market prices at the end of the month.
The market prices used to determine fair values for TEP and MEG's
derivative instruments are estimated based on various factors including broker
quotes, exchange prices, over the counter prices and time value.
TEP and MEG's derivative activities are reported as follows:
INCOME STATEMENT LINE
- -------------------------------------------------------------------------------------------------
NET UNREALIZED GAINS NET REALIZED GAINS
AND LOSSES AND LOSSES
- -------------------------------------------------------------------------------------------------
TEP Forward Sales Contracts Electric Wholesale Sales Electric Wholesale Sales
TEP Forward Purchase Contracts Purchased Power Purchased Power
TEP Commodity Price Swaps Other Comprehensive Income Fuel Expense
(Balance Sheet)
MEG Trading Activities Other Operating Revenues 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 gains and losses from TEP and MEG's derivative activities
were as follows:
Years Ended December 31,
2004 2003 2002
- --------------------------------------------------------------------------------
-Millions of Dollars-
TEP:
Net Unrealized Gain (Loss)
on Forward Sales Contracts $ 1.5 $(0.8) $(1.3)
Net Unrealized Gain (Loss)
on Forward Purchase Contracts (0.2) 0.4 1.8
Net Unrealized Gain on Commodity
Price Swaps 2.6 - -
Net Realized Loss on Commodity
Price Swaps (0.2) - -
MEG:
Net Gain from Trading Activities 1.3 0.6 0.1
- --------------------------------------------------------------------------------
K-114
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
TEP and MEG's derivative assets and liabilities are reported as
follows:
BALANCE SHEET LINE
----------------------------------------------------
ASSETS LIABILITIES
- --------------------------------------------------------------------------------
TEP - Current Other Current Assets Other Current Liabilities
TEP - Noncurrent Other Assets Other Liabilities
MEG - Current (including
Emissions Allowance
Inventory) Trading Assets Trading Liabilities
MEG - Noncurrent Other Assets Other Liabilities
- --------------------------------------------------------------------------------
The fair value of TEP and MEG's derivative assets and liabilities were as
follows:
December 31,
2004 2003
- --------------------------------------------------------------------------------
-Millions of Dollars-
TEP:
Derivative Assets - Current $ 2.3 $ 0.4
Derivative Assets - Noncurrent 1.3 -
Derivative Liabilities - Current (0.1) (0.8)
MEG:
Trading Assets - Current 71.0 20.0
Trading Assets - Noncurrent 5.5 1.5
Trading Liabilities - Current (65.0) (18.2)
Trading Liabilities - Noncurrent - (0.5)
- --------------------------------------------------------------------------------
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. During 2004, $5
million in sales were netted against $5 million in purchases.
In accordance with UniSource Energy's intention to cease making capital
contributions to Millennium, Millennium has significantly reduced the holdings
and activity of MEG. MEG is in the process of winding down its activities and
will not engage in any new activities after 2005. As of January 31, 2005, the
fair value of MEG's trading assets was $62 million and the fair value of MEG's
trading liabilities was $56 million.
NOTE 8. COMMITMENTS AND CONTINGENCIES
- --------------------------------------
TEP COMMITMENTS
PURCHASE AND TRANSPORTATION COMMITMENTS
In 2003, the ACC issued the Track B Order which defined the competitive
bidding process TEP must use to obtain capacity and energy requirements beyond
what is supplied by TEP's existing resources for the period 2003 through 2006.
TEP estimated this to be approximately 0.5% of its retail load in the first year
and gradually increasing over the period. This order further required TEP to bid
out short-term energy purchases that it estimated it will make in the 2003 to
2006 period. The order does not require TEP to purchase any power that it deems
to be uneconomical, unreasonable or unreliable. The Track B Order did not
address TEP's purchased power or asset acquisitions occurring subsequent to the
2003 competitive solicitation. In 2003, TEP entered into two power purchase
agreements for the period 2003 through 2006 as listed below:
o PPL Energy Plus, LLC supplied 37 MW from June 2003 through
December 2003 and supplies 75 MW from January 2004 through
December 2006, under a unit contingent contract.
o Panda Gila River generating station supplies 50 MW on-peak from
June through September, from 2003 through 2005, under a unit
contingent contract between TEP and Panda Gila River, L.P.
These purchases are intended to provide adequate reserve margins during
the summer peak period. TEP made payments under these contracts of $14 million
in 2004 and $8 million in 2003.
TEP has several long-term contracts for the purchase and transportation of
coal with expiration dates from 2006 through 2020. The total amount paid under
these contracts depends on the number of tons of coal purchased and transported.
All of these contracts (i) include a price adjustment clause that will affect
K-115
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
the future cost of coal and (ii) require TEP to pay a take-or-pay charge or
liquidated damages if certain minimum quantities of coal are not purchased
and/or transported. TEP's present fuel requirements are in excess of the
take-or-pay minimums. At times, TEP has purchased coal from other suppliers,
resulting in take-or-pay minimum charges, but a lower overall cost of fuel. TEP
made payments under these contracts of $175 million in 2004, $167 million in
2003, and $161 million in 2002.
TEP has a Gas Procurement Agreement with Southwest Gas Corporation that
expires in June 2006. The contract has minimum volume obligations. TEP used more
gas than this minimum requirement in 2004 and expects to use more than the
minimum in 2005. In the event TEP purchases fewer MMBtus, TEP is obligated to
pay only the transportation component for any shortfall. TEP made total payments
for commodity and transportation under this contract of $34 million in 2004 and
2003, and $33 million in 2002.
At December 31, 2004, TEP estimates that future minimum payments under the
contracts for purchased power, coal, and gas referred to above are as follows:
MINIMUM
PURCHASE
OBLIGATIONS
------------------------------------------------------
-Millions of Dollars-
2005 $ 96
2006 90
2007 79
2008 79
2009 79
------------------------------------------------------
Total 2005 - 2009 423
Thereafter 357
------------------------------------------------------
Total $ 780
======================================================
OPERATING LEASES
TEP, Millennium, UES and UED have entered into operating leases, primarily
for office facilities and computer equipment, with varying terms, provisions,
and expiration dates. UniSource Energy's consolidated operating lease expense
was $3 million in each of 2004, 2003, and 2002. TEP's operating lease expense
was $1 million in 2004 and $2 million in each of 2003 and 2002. UniSource Energy
and TEP's estimated future minimum payments under non-cancelable operating
leases at December 31, 2004 are as follows:
UNISOURCE
ENERGY
CONSOLIDATED TEP
-------------------------------------------------
-Millions of Dollars-
2005 $ 2 $ 1
2006 2 1
2007 2 1
2008 2 1
2009 1 1
-------------------------------------------------
Total 2005 - 2009 9 5
Thereafter 4 1
-------------------------------------------------
Total $13 $ 6
=================================================
ENVIRONMENTAL REGULATION
The 1990 Federal Clean Air Act Amendments call for reductions of SO2 and
nitrogen oxide (NOx) emissions in two phases. TEP is subject only to Phase II of
the SO2 and NOx emissions reductions which was effective January 1, 2000. All of
TEP's generating facilities (except existing internal combustion turbines) are
affected. TEP capitalized $9 million in 2004, $11 million in 2003 and $8 million
in 2002 in construction costs to comply with environmental requirements and
K-116
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
expects to capitalize $1 million in 2005 and $2 million in 2006. These amounts
exclude the upgraded emissions control equipment at the Springerville Generating
Station that will be paid for by the Unit 3 project and recorded at zero basis
by TEP. See Note 14. In addition, TEP recorded expenses of $9 million in 2004,
$8 million in 2003, and $6 million in 2002 related to environmental compliance,
including the cost of lime used to scrub the stacks. TEP expects environmental
expenses to be $8 million in 2005 and 2006.
In 1993, TEP's generating units affected by Phase II were allocated SO2
Emissions Allowances based on past operational history. Beginning in the year
2000, Phase II generating units were required to hold Emissions Allowances equal
to the level of emissions in the compliance year or pay penalties and offset
excess emissions in future years. TEP had sufficient Emissions Allowances to
comply with the Phase II SO2 regulations for compliance year 2004. However, due
to potential changes in the legislation affecting SO2 Emission Allowances
allocation, TEP may have to purchase additional Emissions Allowances for future
compliance years 2010 or beyond.
The EPA has issued a determination that coal and oil-fired electric
utility steam generating units must control their mercury emissions. On March
15, 2005, the EPA adopted regulations relating to mercury emissions under
Section 111 of the Clean Air Act. Additional rule-making procedures will take
place at the state level prior to implementation of the new regulations. TEP is
analyzing the potential impact of the regulations on its operations. Until these
state procedures are adopted, TEP can not determine if it will be significantly
affected. If TEP is not allocated sufficient allowances for its current
emissions, it may have to purchase additional allowances on the market, or
implement additional controls to reduce emissions.
INCOME TAX ASSESSMENTS
In 2004, the Company settled the audit of state income tax returns for the
period 1990 - 2000 with the Arizona Department of Revenue. As a result,
UniSource Energy and TEP recorded $1 million of income. Expense of $1 million
had been recorded at TEP and Nations Energy in 2003 when the preliminary audit
report was received. No additional tax assessments were levied in 2004.
In 2002, the Company settled an IRS audit for 1997-2000, and after
reviewing the impact of the audit findings as well as the effect of tax
positions established in relation to future tax years, TEP reversed $1 million
of the deferred tax valuation allowance. See Note 15.
SALES TAX ASSESSMENTS
In 2004, the City of Tucson issued its assessment for the 1998 - 2001
sales tax audit. After reviewing the audit findings, as well as assessing their
impact on years subsequent to the audit period, TEP recorded a combined $1
million of sales tax and interest expense.
TUCSON TO NOGALES TRANSMISSION LINE
In January 2001, TEP and Citizens (now UES) entered into a project
development agreement for the joint construction of a 62-mile transmission line
from Tucson to Nogales, Arizona. This project was initiated by Citizens (now
UES) in response to an order by the ACC to improve reliability to its retail
customers in Nogales, Arizona. TEP is currently seeking approvals for the
project from the ACC, the Department of Energy (DOE), the U.S. Forest Service,
the U.S. Bureau of Land Management, and the International Boundary and Water
Commission. Through December 31, 2004, approximately $10 million in land
acquisition, engineering and environmental expenses have been capitalized
related to this project. If TEP does not receive the required approvals, it may
be required to expense $8 million of costs that have been capitalized related to
the project.
RESOLUTION OF TEP COMMITMENTS
SUNDT COAL CONTRACT TERMINATION
In the third quarter of 2002, TEP terminated a coal supply agreement for
the Sundt Generating Station. As a result, TEP recorded a pre-tax charge of $11
million and made an $11 million payment in the third quarter of 2002. The
additional expense was mitigated by TEP not being required to make a take-or-pay
penalty payment of approximately $3 million for the year 2002 and subsequent
years.
K-117
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
UES COMMITMENTS
See Note 3 for a description of UES' commitments.
MILLENNIUM COMMITMENTS
Millennium has been authorized to fund its subsidiaries up to an additional
$15 million for capital and operations out of its existing cash or returns from
its investments. Millennium may commit to provide additional funding to its
investments in the future. In addition, at December 31, 2004, Global Solar has
commitments to incur $1 million of expenses related to government contracts.
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 environmental activist groups appealed
the Superior Court decision on December 30, 2003 and filed an amended notice of
appeal on January 2, 2004 with the Arizona Court of Appeals. In February 2005,
the Arizona Court of Appeals upheld the lower court's ruling affirming the ACC's
approval of the expansion at Springerville Generating Station. The Grand Canyon
Trust (GCT), one of the environmental activist groups associated with this
appeal, agreed to resolve this claim against TEP. See Resolution of TEP
Contingencies below. The other environmental activist group has 30 days to
petition the Arizona Supreme Court for review.
LITIGATION AND CLAIMS RELATED TO SAN JUAN GENERATING STATION
The EPA has listed San Juan as a potential damage case pursuant to the
Resource Conservation and Recovery Act due to claims by third parties that the
San Juan Generating Station has contaminated water resources in the region as a
result of disposing of fly ash in the surface mine pits adjacent to the
generating station. PNM and the coal supplier to San Juan vigorously deny these
allegations. The EPA is investigating the claims.
LITIGATION AND CLAIMS RELATED TO NAVAJO GENERATING STATION
On October 15, 2004, Peabody Western Coal Company (Peabody), the coal
suppler to the Navajo Generating Station, filed a complaint in the Circuit Court
for the City of St. Louis, Missouri against the participants at Navajo,
including TEP, for reimbursement of royalties and other costs and breach of the
coal supply agreement. Because TEP only owns 7.5% of the Navajo Generating
Station, its share of the current claimed damages would be approximately $35
million. TEP believes these claims are without merit and intends to continue to
contest them.
POSTRETIREMENT AND PENSION BENEFIT COSTS AT VARIOUS GENERATING STATIONS
The coal suppliers to Springerville Generating Station and some 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.
Springerville Generating Station: In June 2004, TEP paid $3 million in
settlement of a claim for postretirement benefit costs related to the coal
supply agreement at Springerville Generating Station. In addition, a clause was
deleted from the coal supply agreement that would have allowed costs related to
increases in welfare and pension benefits resulting from attempts to unionize or
union negotiations to be passed to TEP. TEP recorded costs of $0.5 million in
2003 and 2004 associated with the settlement for the period April 2002 through
June 2004. The remaining settlement of $2 million represents a prepayment and
will be amortized to coal inventory over the remaining life of the coal supply
agreement through 2010 and expensed as fuel is burned.
K-118
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
Four Corners Generating Station: The claim for postretirement benefits at
Four Corners was settled as part of the coal contract extension. TEP paid $0.3
million for postretirement benefits in 2003.
Navajo Generating Station: Peabody has filed a lawsuit against the
participants at Navajo, including TEP, for retiree postretirement benefit costs.
The Navajo participants and Peabody have agreed to stay the discovery process in
this litigation until August 31, 2005 to allow the parties additional time to
negotiate a potential settlement.
San Juan Generating Station: The cost of postretirement benefits is
included in the cost of coal to San Juan.
To the extent that amounts become estimatable and payment probable, TEP
will record a liability for additional postretirement and pension benefit costs
at the Navajo Generating Station. TEP does not expect any settlement to be
material to TEP.
ENVIRONMENTAL RECLAMATION AT REMOTE GENERATING STATIONS
TEP currently pays on-going reclamation costs related to the coal mines
which supply the remote generating stations, and it is probable that TEP will
have to pay a portion of final reclamation costs upon mine closure. When a
reasonable estimate of final reclamation costs is available, the liability is
recognized as a cost of coal over the remaining term of the respective coal
supply agreement. At December 31, 2004, TEP estimates its undiscounted final
reclamation liability to be $42 million, and the present value of TEP's
liability for final reclamation approximates $12 million at the expiration dates
of the coal supply agreements.
Amounts recorded for final 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 final reclamation obligations will be material to TEP in any
single year since recognition occurs over the remaining lives of its coal supply
agreements.
RESOLUTION OF TEP CONTINGENCY
GRAND CANYON TRUST
In November 2001, GCT 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. In February 2005, TEP and the GCT reached a settlement
under which the GCT will resolve all claims against TEP regarding Springerville
Generating Station. TEP will implement new emission limits at Units 1 and 2 by
January 1, 2006, and, if SRP decides to construct Unit 4 (see Note 14), $1
million will be contributed for each of five years to a demand side management
fund. This settlement is not expected to be material to TEP.
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 Generating 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.
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 air quality permits at San Juan. The NMED issued a draft compliance order
assessing unspecified civil penalties; however, no compliance order has been
issued.
K-119
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
PNM has reached a settlement agreement with the parties that will cause the
above-described actions to be dismissed. Under the agreement, the co-owners of
San Juan will install new technology at the generating station to reduce
mercury, particulate matter, NOx, and SO2 emissions over the next five years.
TEP's share of the cost of new pollution control equipment based on its
ownership of San Juan is anticipated to be approximately $25 million. The
majority of those capital expenditures will be incurred in calendar years 2007,
2008, and 2009. In addition, TEP's share of increased operating and maintenance
costs associated with the new technologies is expected to be approximately $12
million over the next 10 years.
UES CONTINGENCY
See Note 3 for a description of UES' contingency.
MILLENNIUM CONTINGENCY - NATIONS ENERGY
In September 2001, Nations Energy sold its 26% equity interest in a power
project located in Curacao, Netherlands Antilles to Mirant Curacao Investments,
Ltd. (Mirant Curacao) a subsidiary of Mirant Corporation (Mirant). Nations
Energy received $5 million in cash and an $11 million note receivable from
Mirant Curacao. The note was recorded at its net present value of $8 million
using an 8% discount rate, the discount being recognized as interest income over
the five-year life of the note. As of December 31, 2004, Nations Energy's
receivable from Mirant Curacao is approximately $8 million. The note is
primarily included in Investments and Other Property - Other on UniSource
Energy's balance sheet. The first payment of $2 million on the receivable was
received in June 2004. The remaining payments on the note receivable are
expected to be received as follows: $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.
GUARANTEES AND INDEMNITIES
In the normal course of business, UniSource Energy and certain subsidiaries
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:
o 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 utility assets,
o UniSource Energy's guarantee of approximately $8 million in natural
gas transportation and supply payments in addition to building and
equipment lease payments for UNS Gas, UNS Electric, and subsidiaries
of Millennium, and
o Millennium's guarantee of approximately $3 million in
commodity-related payments for MEG and building lease payments for a
subsidiary at December 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 of such investments. 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.
K-120
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
We believe that the likelihood UniSource Energy, 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 9. UTILITY PLANT AND JOINTLY-OWNED FACILITIES
- ---------------------------------------------------
UTILITY PLANT
The following table shows Utility Plant in Service by company and major
class at December 31:
2004 2003
- -------------------------------------------------------------------------------------------------------------------------
- Millions of Dollars -
UniSource UniSource
Energy Energy
TEP UES Consolidated TEP UES Consolidated
-----------------------------------------------------------------------------------
Plant in Service:
Electric Generation Plant $1,206 $ 5 $1,211 $1,187 $ 5 $1,192
Electric Transmission Plant 539 13 552 531 11 542
Electric Distribution Plant 823 74 897 780 61 841
Gas Distribution Plant - 135 135 - 120 120
Gas Transmission Plant - 12 12 - 9 9
General Plant 146 14 160 133 10 143
Intangible Plant 56 7 63 49 2 51
Electric Plant Held for Future
Use 2 1 3 1 - 1
- -------------------------------------------------------------------------------------------------------------------------
Total Plant in Service $2,772 $ 261 $3,033 $2,681 $ 218 $2,899
=========================================================================================================================
Utility Plant under Capital
Leases $ 723 $ 1 $ 724 $ 747 $ 1 $ 748
=========================================================================================================================
Intangible Plant primarily represents computer software costs. TEP's
unamortized computer software costs were $24 million as of December 31, 2004 and
December 31, 2003. UES' unamortized computer software costs were $2 million as
of December 31, 2004 and December 31, 2003.
All TEP Utility Plant under Capital Leases is used in TEP's generation
operations.
The depreciable lives currently used by TEP are as follows:
MAJOR CLASS OF UTILITY PLANT IN SERVICE DEPRECIABLE LIVES
------------------------------------------------------------------------
Electric Generation Plant 23-70 years
Electric Transmission Plant 10-50 years
Electric Distribution Plant 24-60 years
General Plant 5-45 years
Intangible Plant 3-10 years
------------------------------------------------------------------------
During the first quarter of 2004, TEP engaged an independent third party to
review the economic estimated useful lives of its owned generating assets in
Springerville, Arizona. TEP then hired a different independent third party to
perform a depreciation study for its generation assets, taking into
consideration the newly determined economic useful life for the Springerville
assets, and changes in generation plant life information used by the operators
and other participants of the joint power plants in which TEP participates. As a
result of these analyses, in July 2004, TEP lengthened the useful lives of
various generation assets for periods ranging from 11 to 22 years. Consequently,
depreciation rates and the corresponding depreciation expense have been revised
to reflect the life extensions. The annual impact of these changes in
depreciation rates is a reduction in depreciation expense of $9 million. A study
is currently underway by the operating agent of the San Juan Generating Station
K-121
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
to determine whether San Juan's economic useful life has changed from previous
estimates. If the economic life of San Juan is extended by ten years, TEP's
annual depreciation expense would decrease by an additional $4 million.
In the fourth quarter of 2004, TEP determined that one of its capital lease
assets and the corresponding obligation were overstated. To reduce the asset, a
net adjustment of $18 million was recorded and a $20 million reduction to the
obligation was recorded. In addition, a $2 million pre-tax net cumulative
reduction of previously overstated depreciation and interest expense was
recored. See Note 10 and 21.
See TEP Utility Plant in Note 1 and TEP Capital Lease Obligations in Note
10.
The depreciable lives currently used by UES are as follows:
MAJOR CLASS OF UTILITY PLANT IN SERVICE DEPRECIABLE LIVES
------------------------------------------------------------------------
Electric Generation Plant 23-40 years
Electric Transmission Plant 11-45 years
Electric Distribution Plant 14-26 years
Gas Distribution Plant 17-48 years
Gas Transmission Plant 37-55 years
General Plant 3-33 years
------------------------------------------------------------------------
JOINTLY-OWNED FACILITIES
At December 31, 2004, TEP's interests in generating stations and
transmission systems that are jointly-owned with other utilities were as
follows:
Percent Plant Construction
Owned by in Work in Accumulated
TEP Service* Progress Depreciation
- --------------------------------------------------------------------------------
-Millions of Dollars-
San Juan Units 1 and 2 50.0% $302 $ 1 $211
Navajo Station Units 1,
2 and 3 7.5 128 3 69
Four Corners Units 4 and 5 7.0 80 3 65
Transmission Facilities 7.5 to 95.0 226 - 148
Luna Energy Facility 33.3 - 13 -
- --------------------------------------------------------------------------------
Total $736 $20 $493
================================================================================
*Included in Utility Plant shown above.
TEP has financed or provided funds for the above facilities and TEP's share
of their operating expenses is reflected in the income statements. See Note 8
for commitments related to TEP's jointly-owned facilities.
On November 12, 2004, TEP, Phelps Dodge Energy Services, LLC and PNM
Resources, Inc. (PNMR) each purchased from Duke Energy North America, LLC a
one-third interest in a limited liability company which owned the partially
constructed natural gas-fired Luna Energy Facility (Luna). In February 2005,
most of the assets of the limited liability company were transferred to the new
owners so that each owner directly owns a one-third interest in the plant.
Luna is designed as a 570-MW combined cycle plant in southern New Mexico and is
expected to be operational by the summer of 2006. Luna is expected to provide
TEP with 190 MW of power to serve its wholesale and retail customers. PNM, an
affiliate of PNMR, will oversee the completion of construction of Luna, which is
approximately 50 percent complete, and will operate Luna.
TEP paid $13 million for its one-third interest in Luna. TEP expects to
spend up to an additional $33 million for its one-third share of the costs to
complete construction of Luna and purchase necessary inventory items, of which
$30 million will be spent in 2005 and the remainder in 2006. In addition, TEP
expects to spend $3 million for its share of the capital expenditures related to
an anticipated outage in 2009. TEP anticipates that internal cash flows will
fund its share of the costs related to the plant.
K-122
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
NOTE 10. DEBT AND CAPITAL LEASE OBLIGATIONS
- --------------------------------------------
Long-term debt matures more than one year from the date of the financial
statements. UniSource Energy and TEP's long-term debt is summarized in the
statements of capitalization.
UNISOURCE ENERGY DEBT
INTERCOMPANY NOTE PAYABLE
On January 1, 1998, TEP and UniSource Energy exchanged all the outstanding
common stock of TEP on a share-for-share basis for the Common Stock of UniSource
Energy. Following the share exchange, TEP transferred the stock of Millennium to
UniSource Energy for a $95 million promissory note due in 2008. Approximately
$25 million of this note represented a gain to TEP. TEP did not record this gain
in income. Instead, this gain was reflected as an increase in TEP's common stock
equity when UniSource Energy repaid the note on March 1, 2005 (see Subsequent
Events below). In accordance with the ACC order authorizing the formation of the
holding company, interest was payable on the note every two years beginning
January 1, 2000 at a rate of 9.78% per year.
BRIDGE LOAN
In August 2003, UniSource Energy borrowed $35 million from a financial
institution in the form of short-term debt to help finance the purchase of
Citizens Arizona electric and gas utility assets. The funds were recorded as an
equity contribution in the capitalization of UNS Gas and UNS Electric. In
October 2003, as required by the debt agreement, UniSource Energy repaid the $35
million loan upon the financial close of the Springerville Unit 3 project. See
Note 14.
TEP DEBT
LONG-TERM DEBT
TEP made the required sinking fund payments of $2 million on its First
Mortgage IDBs in each of 2004 and 2003. TEP redeemed $0.4 million of its 8.5%
First Mortgage Bonds in 2003 and the remaining $27 million in 2004. TEP paid a
premium of $0.4 million related to the 2004 redemption. A portion of this
premium was expensed immediately, while the remainder is being amortized over
the original life of the bonds. TEP did not issue any new bonds in 2004 or 2003.
FIRST AND SECOND MORTGAGE INDENTURES
TEP's first and second mortgage indentures create liens on and security
interests in most of TEP's utility plant assets, with the exception of
Springerville Unit 2. San Carlos Resources Inc., a wholly-owned subsidiary of
TEP, holds title to Springerville Unit 2. Utility Plant under Capital Leases is
not subject to such liens or available to TEP creditors, other than the lessors.
The net book value of TEP's utility plant subject to the lien of the indentures
was $1,166 million at December 31, 2004.
BANK 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 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 credit agreement also provides that under certain
K-123
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
circumstances, certain regulatory actions could result in a required reduction
of the commitments. As of December 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%, the same rate as the previous agreement. 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 were 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. These fees were related to debt
associated with the generation portion of TEP's operations. Fees of $9 million
associated with the entry into the new facility are being amortized through June
2009. This expense is included in Long-Term Debt Interest Expense in UniSource
Energy and TEP's income statements.
At December 31, 2004, TEP had no outstanding borrowings under the revolving
credit 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%.
TEP also pays a commitment fee of 0.50% on the unused portion of the revolving
credit facility.
TEP CAPITAL LEASE OBLIGATIONS
The terms of TEP's capital leases are as follows:
o The Sundt Lease has an initial term to January 2011 and provides for
renewal periods of two or more years through 2020.
o The Springerville Common Facilities Leases have an initial term to
December 2017 for one lease and January 2021 for the other two leases,
subject to optional renewal periods of two or more years through 2025.
o The Springerville Unit 1 Leases have an initial term to January 2015
and provide for renewal periods of three or more years through 2030.
o The Springerville Coal Handling Facilities Leases have an initial term
to April 2015 and provide for one renewal period of six years, then
additional renewal periods of five or more years through 2035.
On or before each lease expiration date, TEP will determine if it will
purchase the assets at the value stipulated in the lease or renegotiate the
lease term. In some of the leases, the stipulated value is a fixed amount, and
in others it is at fair market value.
SPRINGERVILLE LEASE DEBT AND EQUITY
TEP held an investment in Springerville Unit 1 lease debt totaling $98
million at December 31, 2004 and $100 million at December 31, 2003. TEP
purchased an additional $4 million of Springerville Unit 1 lease debt in 2004,
but made no comparable purchases in 2003. TEP received $7 million in principal
payments related to this investment in each of 2004 and 2003.
In the fourth quarter of 2004, TEP determined that one of its capital lease
assets and the corresponding obligation were overstated. To reduce the
obligation, an adjustment of $20 million was recorded. See Note 9 and 21.
TEP also held an investment in Springerville Coal Handling Facilities lease
debt totaling $73 million at December 31, 2004 and $79 million at December 31,
2003. TEP received $5 million in principal payments related to this investment
in each of 2004 and 2003. TEP purchased a 13% ownership interest in the
Springerville Coal Handling Facilities Leases for $13 million in December 2001
and all $96 million of the debt related to these capital leases in January 2002.
In March 2002, TEP terminated the lease related to its equity interest and
cancelled the associated debt. As a result of the lease termination, TEP
recorded a $21 million reduction to the capital lease obligation, a $27 million
reduction of its investment, and a $6 million increase in the capital lease
asset, which represented the residual value of TEP's interest in the leased
asset.
TEP recognizes interest income on these investments. TEP's purchases of
lease debt and equity are reflected in investing activities on TEP's cash flow
statements.
K-124
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
In 1985, TEP sold and leased back its undivided one-half ownership interest
in the common facilities at the Springerville Generating Station. Under the
terms of the Springerville Common Facilities Leases, TEP must periodically
arrange for refinancing or refunding of the secured notes underlying the leases
prior to the named date in order to avoid a special event of loss. The special
event of loss date is currently set at June 30, 2006. Interest on the debt is
payable at LIBOR plus 4.25%. The LIBOR rate is reset every six months and the
average rate in effect on December 31, 2004 was 1.92%, which resulted in a total
average interest rate on the lease debt of 6.17% at year end.
UNS GAS AND UNS ELECTRIC LONG-TERM DEBT
SENIOR UNSECURED NOTES
On August 11, 2003, UNS Gas and UNS Electric issued a total of $160 million
of aggregate principal amount of senior unsecured notes in a private placement.
Proceeds from the note issuance were paid to Citizens to purchase the Arizona
gas and electric system assets. UNS Gas issued $50 million of 6.23% notes due
August 11, 2011 and $50 million of 6.23% notes due August 11, 2015. UNS Electric
issued $60 million of 7.61% notes due August 11, 2008. All three series of notes
may be prepaid with a make-whole call premium reflecting a discount rate equal
to an equivalent maturity U.S. Treasury security yield plus 50 basis points. UNS
Gas and UNS Electric incurred a total of $2 million in debt costs related to the
issuance of the notes. These costs were deferred and are being amortized over
the life of the notes. The notes are guaranteed by UES.
The note purchase agreements for both UNS Gas and UNS Electric contain
certain restrictive covenants, including restrictions on transactions with
affiliates, mergers, liens to secure indebtedness, restricted payments,
incurrence of indebtedness, and minimum net worth. For purposes of these notes,
net worth equals common stock equity less amounts attributable to minority
interests and intangible assets not recoverable through rates. The actual and
required minimum net worth levels at December 31, 2004 were as follows:
Required
Minimum Net Actual
Net Worth Net Worth
---------------------------------------------
-Millions of Dollars-
UES $ 50 $ 100
UNS Gas 43 59
UNS Electric 26 41
---------------------------------------------
The incurrence of indebtedness covenant requires each of UNS Gas and UNS
Electric to meet certain tests before an additional dollar of indebtedness may
be incurred. These tests include (a) a ratio of Consolidated Long-Term Debt to
Consolidated Total Capitalization of no greater than 0.65 to 1.00, and (b) an
Interest Coverage Ratio (a measure of cash flow to cover interest expense) of at
least 2.50 to 1.00. However, UNS Gas and UNS Electric may, without meeting these
tests, refinance indebtedness and incur short-term debt in an amount not to
exceed $7 million in the case of UNS Gas, and $5 million in the case of UNS
Electric. Neither UNS Gas nor UNS Electric, may declare or make distributions or
dividends (restricted payments) on their common stock unless (a) immediately
after giving effect to such action no default or event of default would exist
under such company's note purchase agreement and (b) immediately after giving
effect to such action, such company would be permitted to incur an additional
dollar of indebtedness under the debt incurrence test for such company. As of
December 31, 2004, UNS Gas and UNS Electric were in compliance with the terms of
the note purchase agreements.
MEG LINE OF CREDIT
MEG has a bank line of credit for the purpose of issuing letters of credit
to counterparties to support its emissions allowance and coal trading
activities. In September 2004, MEG reduced this bank line of credit from $5
million to $3 million. As of December 31, 2004, MEG had $2 million in
outstanding LOCs, all of which had expired by the end of February 2005. In
accordance with UniSource Energy's intention to cease making capital
contributions to Millennium, Millennium has significantly reduced the holdings
and activity of MEG. MEG is in the process of winding down its activities and
will not engage in any new activities after 2005. MEG's bank line of credit
will expire on March 27, 2005 and will not be renewed.
K-125
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
MATURITIES AND SINKING FUND REQUIREMENTS
Long-term debt, including sinking funds, and capital lease obligations
mature on the following dates:
Scheduled
IDBs Long-Term Capital UniSource
Supported Debt Lease TEP UNS UNS Energy
by LOCs Retirements (1) Obligations Total Gas Electric Total
------------- ------------------- --------------- ----------- ----------- ------------ -------------
-Millions of Dollars-
2005 $ - $ 2 $ 120 $ 122 $ - $ - $ 122
2006 - 21 123 144 - - 144
2007 - 1 128 129 - - 129
2008 - 167 121 288 - 60 348
2009 329 - 68 397 - - 397
--------------------------------------------------------------------------------------------------------------------------------
Total 2005-2009 329 191 560 1,080 - 60 1,140
Thereafter - 579 780 1,359 100 - 1,459
Less: Imputed Interest - - (585) (585) - - (585)
--------------------------------------------------------------------------------------------------------------------------------
Total $ 329 $ 770 $ 755 $ 1,854 $ 100 $ 60 $ 2,014
================================================================================================================================
(1) As discussed above, TEP redeemed its remaining First Mortgage IDBs in
March 2005. If this redemption were reflected in this table, the only
remaining Scheduled Long-Term Debt Retirement for 2005-2009 would be $138
million in 2008.
SUBSEQUENT EVENTS
On March 1, 2005, UniSource Energy issued $150 million aggregate principal
amount of 4.50% Convertible Senior Notes due 2035 through a domestic offering to
qualified institutional buyers pursuant to Rule 144A under the Securities Act of
1933 (the Act) and to persons in offshore transactions in reliance on Regulation
S under the Act. Each $1,000 principal amount of notes is convertible into
26.6667 shares of UniSource Energy Common Stock at any time, representing a
conversion price of approximately $37.50 per share of UniSource Energy Common
Stock, subject to adjustment in certain circumstances. Beginning on March 5,
2010, UniSource Energy will have the option to redeem the notes, in whole or in
part, for cash, at a price equal to 100% of the principal amount plus accrued
and unpaid interest. Holders of the notes will have the ability to require
UniSource Energy to repurchase the notes, in whole or in part, for cash on March
1, 2015, 2020, 2025 and 2030, or if certain specified fundamental changes
involving UniSource Energy occur. The repurchase price will be 100% of the
principal amount of the notes plus accrued and unpaid interest.
On March 1, 2005, UniSource Energy used $106 million of the net proceeds
from this offering to repay the $95 million promissory note to TEP plus accrued
interest of $11 million. UniSource Energy expects that TEP will use these funds
to redeem or repurchase certain of TEP's existing indebtedness through
transactions that may include negotiated or market purchases, tender offers and
redemptions. TEP has not yet determined the series of debt to be redeemed or
repurchased.
TEP made the required sinking fund payment of $1 million on its 6.1% First
Mortgage IDBs in January 2005. In March 2005, TEP redeemed at par the remaining
$31 million of its 6.1% First Mortgage IDBs, which were due in 2008, as well as
the remaining $21 million of its 7.5% First Mortgage IDBs, which were due in
2006.
NOTE 11. FAIR VALUE OF FINANCIAL INSTRUMENTS
- ---------------------------------------------
The carrying values and fair values of our financial instruments are as
follows:
K-126
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
December 31,
2004 2003
---------------------------------------------------
Carrying Fair Carrying Fair
Value Value Value Value
---------------------------------------------------
-Millions of Dollars-
ASSETS:
TEP Springerville Lease Debt Securities (included in
Investments and Other Property) $ 171 $ 182 $ 179 $ 198
LIABILITIES:
TEP First Mortgage Bonds - Fixed Rate:
Corporate - - 27 27
IDBs 53 53 55 55
First Collateral Trust Bonds 138 153 138 155
TEP Second Mortgage Bonds - IDBs (Variable Rate) 329 329 329 329
TEP Unsecured IDBs - Fixed Rate 579 568 579 582
UNS Gas Senior Unsecured Notes 100 108 100 100
UNS Electric Senior Unsecured Notes 60 64 60 60
---------------------------------------------------
See Note 10 for a description of TEP's investment in Springerville Lease
Debt. TEP intends to hold the $171 million investment in Springerville Lease
Debt Securities to maturity ($39 million matures through January 1, 2009, $73
million matures through July 1, 2011, and $59 million matures through January 1,
2013). This investment is stated at amortized cost, which means the purchase
cost has been adjusted for the amortization of the premium and discount to
maturity. TEP determined the fair value of this investment by calculating the
present value of the cash flows of each note, using a discount rate consistent
with market yields generally available as of December 31, 2004 and December 31,
2003 for bonds with similar characteristics with respect to credit rating and
time-to-maturity. The use of different market assumptions and/or estimation
methodologies may yield different estimated fair value amounts.
TEP considers the principal amounts of variable rate debt outstanding to be
reasonable estimates of their fair value. TEP determined the fair value of its
taxable fixed rate obligations including the Corporate First Mortgage Bonds and
First Collateral Trust Bonds by calculating the present value of the cash flows
of each fixed rate obligation. TEP used a rate consistent with market yields
generally available as of December 31, 2004 and December 31, 2003 for bonds with
similar characteristics with respect to credit rating and time-to-maturity. The
use of different market assumptions and/or estimation methodologies may yield
different estimated fair value amounts. TEP based the fair value of its
tax-exempt fixed rate obligations including the First Mortgage IDBs and the
Unsecured IDBs on quoted market prices for the same or similar debt.
As of December 31, 2004, UNS Gas and UNS Electric determined the fair value
of the $160 million of senior unsecured notes by calculating the present value
of the cash flows of each note, using a discount rate consistent with market
yields generally available as of December 31, 2004 for bonds with similar
characteristics with respect to credit rating and time-to-maturity. The use of
different market assumptions and/or estimation methodologies may yield different
estimated fair value amounts. As of December 31, 2003, UNS Gas and UNS Electric
considered the principal amounts of these notes, which were issued in August
2003, to be reasonable estimates of their fair value.
The carrying amounts of our current assets and liabilities approximate fair
value.
NOTE 12. STOCKHOLDERS' EQUITY
- ------------------------------
DIVIDEND LIMITATIONS
UNISOURCE ENERGY
In February 2005, UniSource Energy declared a quarterly dividend to the
shareholders of $0.19 per share of UniSource Energy Common Stock. The dividend,
totaling approximately $7 million, was paid on March 8, 2005 to common
shareholders of record as of February 15, 2005. In 2004, UniSource Energy paid
quarterly dividends to the shareholders of $0.16 per share, for a total of $0.64
per share, or $22 million, for the year. During 2003, UniSource Energy paid
quarterly dividends to the shareholders of $0.15 per share, for a total of $0.60
K-127
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
per share, or $20 million, for the year. During 2002, UniSource Energy paid
quarterly dividends to the shareholders of $0.125 per share, for a total of
$0.50 per share, or $17 million, for the year.
Our ability to pay cash dividends on Common Stock outstanding depends, in
part, upon cash flows from our subsidiaries: TEP, UES, Millennium and UED.
Additionally, as a result of the acquisition agreement discussed in Note 2,
UniSource Energy's quarterly dividend payment was limited to no more than $0.16
per share in 2004.
TEP
TEP paid dividends of $32 million in 2004, $80 million in 2003, and $35
million in 2002. UniSource Energy is the primary holder of TEP's common stock.
TEP met the following requirements before paying these dividends:
o BANK CREDIT AGREEMENT
TEP's new Credit Agreement as of March 2004 allows TEP to pay dividends as
long as TEP maintains compliance with the agreement and certain financial
covenants.
o ACC HOLDING COMPANY ORDER
The ACC Holding Company Order does not allow TEP to pay dividends in
excess of 75% of its annual earnings until TEP's equity ratio equals 37.5% of
total capitalization, excluding capital lease obligations. The UES Settlement
Agreement, as approved by the ACC, modifies this dividend limitation so that it
will remain in place until TEP's common equity equals 40% of total
capitalization (excluding capital lease obligations).
o FEDERAL POWER ACT
This Act states that dividends shall not be paid out of funds properly
included in capital accounts. TEP's 2004, 2003 and 2002 dividends were paid from
current year earnings.
UES
UES did not pay any dividends to UniSource Energy in 2004 or 2003. UES'
ability to pay dividends is limited by restrictions placed on its subsidiaries,
UNS Gas and UNS Electric. As discussed in Note 3, the UES Settlement Agreement
limits dividends payable by both UNS Gas and UNS Electric to UniSource Energy to
75% of earnings until the ratio of common equity to total capitalization reaches
40%. UNS Electric met this ratio requirement at December 31, 2004. Additionally,
the terms of the senior unsecured note agreements entered into by both UNS Gas
and UNS Electric contain dividend restrictions. See Note 10.
MILLENNIUM AND UED
Millennium did not pay any dividends to UniSource Energy in 2004, 2003 or
2002. UED did not pay any dividends to UniSource Energy in 2004 or 2002. UED
paid a dividend to UniSource Energy of $50 million in 2003. Millennium and UED
have no dividend restrictions.
UNISOURCE ENERGY SHAREHOLDER RIGHTS PLAN
In March 1999, UniSource Energy adopted a Shareholder Rights Plan. As of
April 1, 1999, each Common Stock shareholder receives one Right for each share
held. Each Right initially allows shareholders to purchase UniSource Energy's
Series X Preferred Stock at a specified purchase price. However, the Rights are
exercisable only if a person or group (the "acquirer") acquires or commences a
tender offer to acquire 15% or more of UniSource Energy Common Stock. Each Right
would entitle the holder (except the acquirer) to purchase a number of shares of
UniSource Energy Common or Preferred Stock (or, in the case of a merger of
UniSource Energy into another person or group, common stock of the acquiring
person) having a fair market value equal to twice the specified purchase price.
At any time until any person or group has acquired 15% or more of the Common
Stock, UniSource Energy may redeem the Rights at a redemption price of $0.001
per Right. The Rights trade automatically with the Common Stock when it is
bought and sold. The Rights expire on March 31, 2009.
K-128
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
NOTE 13. TEP WHOLESALE ACCOUNTS RECEIVABLE AND ALLOWANCES
- ----------------------------------------------------------
TEP's Accounts Receivable from Electric Wholesale Sales, included in Trade
Accounts Receivable on the balance sheet, totaled $22 million at December 31,
2004 and $26 million at December 31, 2003, net of allowances. TEP's Allowance
for Doubtful Accounts on the balance sheet includes $13 million at December 31,
2004 and $10 million at December 31, 2003 related to sales to the California
Power Exchange (CPX) and the California Independent System Operator (CISO) in
2001 and 2000. Excluding the receivables from the CPX and the CISO,
substantially all of the December 31, 2004 wholesale receivable balance has been
collected as of the date of this filing.
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 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. Based upon a FERC order in March 2003
(as reaffirmed by the FERC on October 16, 2003), TEP estimated that it would
receive approximately $6 million of its $16 million receivable. In May 2004, the
FERC issued two separate orders addressing numerous issues in the refund
calculation and the fuel cost allowance calculation (an offset to the refund
obligation). Based on these new orders, TEP increased its reserve for sales to
the CPX and the CISO by $3 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.
NOTE 14. SPRINGERVILLE EXPANSION
- ---------------------------------
On October 21, 2003 (the Closing Date), UED, TEP, Tri-State Generation and
Transmission Association, Inc. (Tri-State) and Salt River Project Agricultural
Improvement and Power District (SRP) entered into an Amended and Restated Joint
Development Agreement, which provides for the development of two 400 MW
coal-fired units at TEP's existing Springerville Generating Station by parties
other than TEP.
On the Closing Date, TEP transferred the right to construct Unit 3,
together with associated rights, to Tri-State. Tri-State completed financing of
Unit 3 on that date and immediately began construction. Once the unit is
completed, Tri-State will lease 100% of Unit 3 through a 34-year leveraged lease
agreement with GE Structured Finance and will take 300 MW of the 400 MW
capacity.
Under the Joint Development Agreement, SRP will purchase 100 MW of Unit
3's capacity from Tri-State under a 30-year power purchase agreement and will
have the right to construct and own Unit 4 at a later date. If SRP decides to
construct Unit 4, TEP and Tri-State may be required to find a replacement
purchaser for SRP's 100 MW power purchase obligation from Unit 3. If TEP and
Tri-State are unable to find a replacement purchaser, TEP would then purchase
100 MW of output from Unit 4, beginning with its commercial operation.
TEP executed contracts to provide operating, maintenance and other
services to Units 3 and 4. TEP also agreed to purchase up to 100 MW of Tri-State
system capacity for no more than five years from the time Unit 3 begins
commercial operation, which we expect to occur in December 2006. TEP will
benefit from approximately $90 million in upgraded emissions control equipment
for Units 1 and 2 and other facilities at the Springerville Generating Station
that will be paid for by the Unit 3 project. Due to the transfer of Unit 3
rights to Tri-State, in November 2003 TEP deposited $17 million with TEP's
Second Mortgage Trustee in compliance with TEP's Credit Agreement. Such deposit
was returned to TEP in 2004 when TEP refinanced its Credit Agreement and
eliminated this requirement.
On the Closing Date, UED received reimbursement of all project development
costs which it incurred in connection with Units 3 and 4 of approximately $29
million, plus a development fee (including accrued interest on development funds
advanced) of $11 million. We recognized the development fee as income in the
fourth quarter of 2003. On October 24, 2003, UniSource Energy repaid its $35
million short-term bridge loan with the proceeds.
K-129
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
NOTE 15. INCOME AND OTHER TAXES
- --------------------------------
INCOME TAXES
We record deferred tax liabilities for amounts that will increase income
taxes on future tax returns. We record deferred tax assets for amounts that
could be used to reduce income taxes on future tax returns. We record a Deferred
Tax Assets Valuation Allowance for the amount of Deferred Tax Assets that we may
not be able to use on future tax returns. We estimate the valuation allowance
based on our interpretation of the tax rules, prior tax audits, tax planning
strategies, scheduled reversal of deferred tax liabilities, and projected future
taxable income.
Deferred tax assets (liabilities) consist of the following:
UNISOURCE ENERGY TEP
----------------------------------------------------------------
December 31, December 31,
2004 2003 2004 2003
- ------------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
GROSS DEFERRED INCOME TAX LIABILITIES
Plant - Net $ (478) $ (476) $ (470) $ (474)
Income Taxes Recoverable Through Future
Revenues Regulatory Asset (20) (22) (20) (22)
Transition Recovery Asset (89) (108) (89) (108)
Other (33) (31) (27) (27)
- ------------------------------------------------------------------------------------------------------------------------
GROSS DEFERRED INCOME TAX LIABILITY (620) (637) (606) (631)
- ------------------------------------------------------------------------------------------------------------------------
GROSS DEFERRED INCOME TAX ASSETS
Capital Lease Obligations 314 337 314 337
Net Operating Loss Carryforwards (NOL) 7 18 - 11
Investment Tax Credit Carryforwards 5 8 5 8
Alternative Minimum Tax Credit (AMT) 100 88 92 85
Accrued Postretirement Benefits 19 17 19 17
Emission Allowance Inventory 14 14 14 14
Coal Contract Termination Fees 14 16 14 16
Springerville Coal Handling Facility 6 7 6 7
Reserve for Uncollectible Accounts 6 4 6 4
Unregulated Investment Losses 30 30 1 1
Minimum Pension Liability 7 1 7 1
Vacation & Sick Accrual 3 3 3 3
Other 25 21 20 18
- ------------------------------------------------------------------------------------------------------------------------
GROSS DEFERRED INCOME TAX ASSET 550 564 501 522
DEFERRED TAX ASSETS VALUATION ALLOWANCE (8) (7) (1) -
- ------------------------------------------------------------------------------------------------------------------------
NET DEFERRED INCOME TAX LIABILITY $ (78) $ (80) $ (106) $ (109)
========================================================================================================================
The net deferred income tax liability is included in the balance sheets in
the following accounts:
UNISOURCE ENERGY TEP
--------------------------------------------------------------
December 31, December 31,
2004 2003 2004 2003
- ------------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Deferred Income Taxes - Current Assets $ 24 $ 16 $ 24 $ 19
Deferred Income Taxes - Noncurrent Liabilities (102) (96) (130) (128)
- ------------------------------------------------------------------------------------------------------------------------
NET DEFERRED INCOME TAX LIABILITY $ (78) $ (80) $ (106) $ (109)
========================================================================================================================
The valuation allowance of $8 million at December 31, 2004 and $7 million
at December 31, 2003, which reduces the Deferred Tax Asset balance, relates to
Net Operating Loss (NOL) and Investment Tax Credit (ITC) carryforward amounts.
K-130
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
The increase of $1 million is related to TEP's ITC carryforward. Of the $8
million valuation allowance at December 31, 2004, $7 million relates to losses
generated by the Millennium entities. In the future, if UniSource Energy and the
Millennium entities determine that all or a portion of the losses may be used on
tax returns, then UniSource Energy and the Millennium entities would reduce the
valuation allowance and recognize benefit of up to $7 million. The primary
factor that could cause the Millennium entities to recognize a tax benefit would
be a change in expected future taxable income. The remaining $1 million
valuation allowance at December 31, 2004 relates to ITC carryfowards at TEP
which may not be utilized on tax returns prior to their expiration. If in the
future UniSource Energy and TEP determine that it is probable that TEP will not
use all or a portion of additional ITC carryforward amounts, then UniSource
Energy and TEP would record additional valuation allowance and recognize tax
expense. The primary factor that could cause TEP to record additional valuation
allowance would be a change in expected future taxable income.
In 2003, the Deferred Tax Assets Valuation Allowance decreased $15 million
due primarily to TEP's expectation of using a portion of its NOL and ITC
carryforward amounts. This resulted in the reduction of Income Tax Expense for
the year ended December 31, 2003.
In 2002, the Deferred Tax Assets Valuation Allowance decreased $1 million
due primarily to the settlement of audits.
As of December 31, 2004 UniSource Energy's deferred income tax assets
include $14 million related to unregulated investment losses of Millennium.
TEP's deferred income tax assets include $1 million related to unregulated
investment losses. These losses have not been reflected on UniSource Energy
consolidated income tax returns. If UniSource Energy is unable to recognize such
losses through its consolidated income tax return in the forseeable future,
UniSource Energy and TEP would be required to write off these deferred tax
assets. Millennium intends to restructure its ownership in one of these
investments, Infinite Power Solutions (IPS), in 2005. As a result of this
restructuring, we expect to liquidate IPS for tax purposes resulting in a
taxable loss that will be reflected on UniSource Energy's consolidated income
tax return. If this liquidation, or another action resulting in the recognition
of the loss for tax purposes, does not occur UniSource Energy would be required
to eliminate the deferred tax assets and recognize additional tax expense of $6
million.
TEP had a net intercompany tax payable to affiliates of $4 million at
December 31, 2004 and $2 million at December 31, 2003. These amounts are
included in TEP's intercompany accounts on its balance sheet.
In 2004, UniSource Energy recognized $1 million of tax benefit as a result
of the settlement of a state income tax audit. This amount is included in the
income tax expense (benefit) tables below.
In 2003, UniSource Energy recognized $1 million of tax and interest
expense in anticipation of settlement of state income tax audits and settlement
of a state sales tax audit. The income taxes are included in the expense
(benefit) tables below.
In 2002, UniSource Energy recognized a tax benefit of $1.5 million as a
result of final agreement with the IRS on audit issues and a tax benefit of
$1 million from recognition of losses generated by the sale of a Nations Energy
foreign entity.
In 2004, the tax effect of the exercise of certain employee stock options
that are recognized differently for financial reporting and tax purposes was not
recorded as a timing difference, but rather was credited to shareholder's
equity. This resulted in a $1.5 million increase to the capital of UniSource
Energy.
Additionally, in 2004, as a result of the termination of the UniSource
Energy acquisition, UniSource Energy and TEP deducted certain legal and advisory
fees which had previously been treated as permanently nondeductible expense. As
a result, a current tax benefit of $1.1 million was recognized in the fourth
quarter of 2004.
K-131
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
Income tax expense (benefit) included in the income statements consists of
the following:
UNISOURCE ENERGY TEP
------------------------------ ----------------------------
Years Ended December 31,
2004 2003 2002 2004 2003 2002
- --------------------------------------------------------------------------- ----------------------------
-Millions of Dollars-
Current Tax Expense
Federal $ 21 $ 11 $ 20 $ 28 $ 14 $ 23
State 7 5 7 8 7 8
- --------------------------------------------------------------------------- ----------------------------
Total 28 16 27 36 21 31
- --------------------------------------------------------------------------- ----------------------------
Deferred Tax Expense (Benefit)
Federal 7 12 (1) - 16 9
State (2) (1) (7) (2) (1) (3)
- --------------------------------------------------------------------------- ----------------------------
Total 5 11 (8) (2) 15 6
- --------------------------------------------------------------------------- ----------------------------
Increase (Reduction) in Valuation
Allowance 1 (15) (1) 1 (15) (1)
- --------------------------------------------------------------------------- ----------------------------
Total Federal and State Income Tax
Expense Before Cumulative Effect
of Accounting Change 34 12 18 35 21 36
- --------------------------------------------------------------------------- ----------------------------
Tax On Cumulative Effect of
Accounting Change (See Note 5) - 44 - - 44 -
- --------------------------------------------------------------------------- ----------------------------
Total Federal and State Income
Tax Expense Including Cumulative
Effect of Accounting Change $ 34 $ 56 $ 18 $ 35 $ 65 $ 36
=========================================================================== ============================
The differences between the income tax expense and the amount obtained by
multiplying pre-tax income by the U.S. statutory federal income tax rate of 35%
are as follows:
UNISOURCE ENERGY TEP
---------------------------------------------------------------
Years Ended December 31,
2004 2003 2002 2004 2003 2002
- ----------------------------------------------------------------------------------------------------------
-Millions of Dollars-
FEDERAL INCOME TAX EXPENSE AT
STATUTORY RATE $ 28 $ 21 $ 19 $ 28 $ 29 $ 33
State Income Tax Expense,
Net of Federal Deduction 4 3 2 4 4 4
Depreciation Differences
(Flow Through Basis) 3 4 4 3 4 4
Federal/State Credits (1) (2) (4) (1) (2) (4)
Increase (Reduction) in Valuation
Allowance 1 (15) (1) 1 (15) (1)
Other (1) 1 (2) - 1 -
- ----------------------------------------------------------------------------------------------------------
Total Federal and State Income Tax
Expense Before Cumulative Effect
of Accounting Change $ 34 $ 12 $ 18 $ 35 $ 21 $ 36
==========================================================================================================
The Total Federal and State Income Tax Expense in the tables above is
included on UniSource Energy and TEP's income statements.
At December 31, 2004, UniSource Energy and TEP had, for federal and state
income tax filing purposes, the following carryforward amounts:
UNISOURCE ENERGY TEP
---------------------------------------- --------------------------------------
Amount Expiring Amount Expiring
---------------------------------------- --------------------------------------
-Millions of Dollars- Year -Millions of Dollars- Year
- ----------------------------------------------------------------------------------------------------------
Net Operating Losses $ 18 2021-2022 $ - -
Investment Tax Credit 5 2004-2024 5 2004-2024
AMT Credit 100 - 92 -
- ----------------------------------------------------------------------------------------------------------
K-132
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
The $18 million in NOL carryforwards at UniSource Energy is subject to
limitation due to a reorganization of certain Millennium entities in December
2002. The future utilization of these losses is dependant upon the generation of
sufficient future taxable income at the separate company level.
OTHER TAXES
TEP and UES act as conduits or collection agents for excise tax (sales
tax) as well as franchise fees and regulatory assessments. They record
liabilities payable to governmental agencies when they bill their customers for
these amounts. Neither the amounts billed nor payable are reflected in the
income statement.
NOTE 16. EMPLOYEE BENEFIT PLANS
- --------------------------------
PENSION BENEFIT PLANS
TEP and UES maintain noncontributory, defined benefit pension plans for
substantially all regular employees and certain affiliate employees. Benefits
are based on years of service and the employee's average compensation. TEP and
UES fund the plans by contributing at least the minimum amount required under
Internal Revenue Service regulations. Additionally, we provide supplemental
retirement benefits to certain employees whose benefits are limited by IRS
benefit or compensation limitations.
OTHER POSTRETIREMENT BENEFIT PLANS
TEP provides limited health care and life insurance benefits for retirees.
All regular employees may become eligible for these benefits if they reach
retirement age while working for TEP or an affiliate.
TEP amended its other postretirement benefit plan to cap Medicare
supplement payments for all current retirees under age 65 and all classified
employees retiring after December 31, 2002 and eliminate post-65 medical
benefits for all salaried employees retiring after January 1, 2002. These
amendments required TEP to recalculate benefits related to participants' past
service. TEP is amortizing the change in the benefit cost from these plan
amendments on a straight-line basis over 10 years.
UniSource Energy acquired the Arizona gas and electric system assets from
Citizens on August 11, 2003, assuming a $2 million liability for postretirement
medical benefits for current retirees and a small group of active employees. The
majority of UES employees do not currently participate in the postretirement
medical plan.
The ACC allows TEP and UES to recover postretirement costs through rates
only as benefit payments are made to or on behalf of retirees. The
postretirement benefits are currently funded entirely on a pay-as-you-go basis.
Under current accounting guidance, TEP and UES cannot record a regulatory asset
for the excess of expense calculated per Statement of Financial Accounting
Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than
Pensions, over actual benefit payments.
FASB Staff Position No. FAS 106-2, Accounting and Disclosure Requirements
Related to the Medicare Prescription Drug, Improvement and Modernization Act of
2003 (FSP 106-2), provides guidance related to accounting for the federal
subsidy available to certain employers providing retirees with prescription drug
benefits. For public companies, FSP 106-2 is effective for the first interim or
annual period beginning after June 15, 2004. Adoption of FSP 106-2 did not have
a significant impact on our postretirement benefit costs or cash flows because
prescription drug coverage is only available to a limited number of UniSource
Energy retirees who are Medicare eligible.
The actuarial present values of all pension benefit obligations and other
postretirement benefit plans were measured at December 1. The tables below
include both TEP and UES plans. Amounts included for UES plans are not
significant. The change in benefit obligation and plan assets and reconciliation
of the funded status are as follows:
K-133
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
OTHER POSTRETIREMENT
PENSION BENEFITS BENEFITS
------------------------------------------------------------
Years Ended December 31,
2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
CHANGE IN BENEFIT OBLIGATION
Benefit Obligation at Beginning of Year $ 162 $ 133 $ 68 $ 59
Actuarial (Gain) Loss 16 16 (1) 3
Interest Cost 10 9 3 4
Service Cost 6 5 2 2
Benefits Paid (6) (5) (2) (2)
Plan Amendments - 4 - -
Acquisition Adjustment - - - 2
- ----------------------------------------------------------------------------------------------------------------------
Benefit Obligation at End of Year 188 162 70 68
- ----------------------------------------------------------------------------------------------------------------------
CHANGE IN PLAN ASSETS
Fair Value of Plan Assets at Beginning of Year 124 106 - -
Actual Return on Plan Assets 12 20 - -
Benefits Paid (6) (5) (2) (2)
Employer Contributions 6 3 2 2
- ----------------------------------------------------------------------------------------------------------------------
Fair Value of Plan Assets at End of Year 136 124 - -
- ----------------------------------------------------------------------------------------------------------------------
RECONCILIATION OF FUNDED STATUS TO BALANCE SHEET
Funded Status (Difference between Benefit
Obligation and Fair Value of Plan Assets) (52) (38) (70) (68)
Unrecognized Net Loss 50 37 30 33
Unrecognized Prior Service Cost (Benefit) 13 15 (10) (11)
- ----------------------------------------------------------------------------------------------------------------------
Net Amount Recognized in the Balance Sheets $ 11 $ 14 $ (50) $ (46)
======================================================================================================================
AMOUNTS RECOGNIZED IN THE BALANCE SHEETS
CONSIST OF:
Prepaid Pension Costs Included in Other Assets $ 17 $ 10 $ - $ -
Accrued Benefit Liability Included in Other
Liabilities (35) (9) (50) (46)
Intangible Asset Included in Other Assets 9 10 - -
Accumulated Other Comprehensive Income 20 3 - -
- ------------------------------------------------------------------------------------------------------------------------
Net Amount Recognized $ 11 $ 14 $ (50) $ (46)
========================================================================================================================
The accumulated benefit obligation (ABO) for all defined benefit pension
plans was $154 million and $130 million at December 31, 2004 and 2003,
respectively. The ABO was impacted by changes in actuarial assumptions including
revised retirement rates and updated mortality rates in addition to a reduction
in the discount rate.
DECEMBER 31,
2004 2003
- --------------------------------------------------------------------------------
-Millions of Dollars-
INFORMATION FOR PENSION PLANS WITH AN
ACCUMULATED BENEFIT OBLIGATION IN
EXCESS OF PLAN ASSETS:
Projected Benefit Obligation at
End of Year $ 188 $ 87
Accumulated Benefit Obligation at
End of Year 154 70
Fair Value of Plan Assets at
End of Year $ 136 $ 61
- --------------------------------------------------------------------------------
K-134
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
The components of net periodic benefit costs are as follows:
OTHER POSTRETIREMENT
PENSION BENEFITS BENEFITS
------------------------------------------------------------
Years Ended December 31,
2004 2003 2002 2004 2003 2002
- ----------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
COMPONENTS OF NET PERIODIC COST
Service Cost $ 6 $ 5 $ 5 $ 2 $ 2 $ 2
Interest Cost 10 9 8 3 4 4
Expected Return on Plan Assets (10) (9) (11) - - -
Prior Service Cost Amortization 2 2 2 (1) (1) -
Recognized Actuarial Loss 2 2 - 2 2 2
- ----------------------------------------------------------------------------------------------------------------------
Net Periodic Benefits Cost (Benefit) $ 10 $ 9 $ 4 $ 6 $ 7 $ 8
======================================================================================================================
For all pension plans, prior service costs are amortized on a straight-line
basis over the average remaining service period of employees expected to receive
benefits under the plan.
ADDITIONAL INFORMATION OTHER POSTRETIREMENT
PENSION BENEFITS BENEFITS
------------------------------------------------------------
Years Ended December 31,
2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Minimum Pension Liability Included in
Other Comprehensive Income $ 20 $ 3 N/A N/A
- ----------------------------------------------------------------------------------------------------------------------
OTHER POSTRETIREMENT
PENSION BENEFITS BENEFITS
------------------------------------------------------------
2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------------------------------
WEIGHTED-AVERAGE ASSUMPTIONS USED TO DETERMINE
BENEFIT OBLIGATIONS AS OF DECEMBER 1,
Discount Rate 6.00 - 6.10% 6.25% 5.90% 5.50%
Rate of Compensation Increase 3.00 - 5.00% 4.00% - -
- ----------------------------------------------------------------------------------------------------------------------
OTHER POSTRETIREMENT
PENSION BENEFITS BENEFITS
------------------------------------------------------------
2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------------------------------
WEIGHTED-AVERAGE ASSUMPTIONS USED TO DETERMINE
NET PERIODIC BENEFIT COST FOR YEARS ENDED
DECEMBER 31,
Discount Rate 6.25% 6.75% 5.50% 6.75%
Rate of Compensation Increase 3.00 - 5.00% 4.00% - -
Expected Return on Plan Assets 8.75% 8.75% - -
- ----------------------------------------------------------------------------------------------------------------------
Net periodic benefit cost is subject to various assumptions and
determinations, such as the discount rate, the rate of compensation increase,
and the expected return on plan assets. We estimated the expected return on plan
assets based on a review of the plans' asset allocations and consultations with
a third-party investment consultant and the plans' actuary considering market
and economic indicators, historical market returns, correlations and volatility,
central banks' and government treasury departments' forecasts and objectives,
and recent professional or academic research. Changes that may arise over time
with regard to these assumptions and determinations will change amounts recorded
in the future as net periodic benefit cost.
K-135
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
DECEMBER 31,
2004 2003
- --------------------------------------------------------------------------------
ASSUMED HEALTH CARE COST TREND RATES
Health Care Cost Trend Rate Assumed
for Next Year 11.00% 12.10%
Ultimate Health Care Cost Trend Rate
Assumed 5.00% 5.00%
Year that the Rate Reaches the
Ultimate Trend Rate 2013 2013
- --------------------------------------------------------------------------------
Assumed health care cost trend rates have a significant effect on the
amounts reported for health care plans. A one-percentage-point change in assumed
health care cost trend rates would have the following effects on the December
31, 2004 amounts:
ONE-PERCENTAGE-POINT ONE-PERCENTAGE-POINT
INCREASE DECREASE
- --------------------------------------------------------------------------------
-Millions of Dollars-
Effect on Total of Service and
Interest Cost Components $ 1 $ -
Effect on Postretirement Benefit
Obligation $ 5 $ (4)
- --------------------------------------------------------------------------------
PLAN ASSETS
TEP and UES calculate the market-related value of plan assets using the
fair value of plan assets on the measurement date. The UES pension plan was
initially funded during 2004. TEP and UES' pension plan asset allocations at
December 31, 2004 and TEP's pension plan asset allocations at December 31, 2003,
by asset category are as follows:
PLAN ASSETS
DECEMBER 31,
2004 2003
- -------------------------------------------------------------
ASSET CATEGORY
Equity Securities 68.25% 68.1%
Debt Securities 18.23% 18.2%
Real Estate 13.52% 13.7%
Other - -
- -------------------------------------------------------------
Total 100.0% 100.0%
=============================================================
TEP's investment policy for the pension plans targets a range of exposure
to the various asset classes surrounding the following allocations: equity
securities 65%, debt securities 23% and real estate 12%. TEP rebalances the
portfolio periodically when the portfolio allocation is not within the desired
range of exposure. The plan seeks to provide returns in excess of the portfolio
benchmark. The portfolio benchmark consists of the following indices: 55% S&P
500; 10% MSCI EAFE; 23% Lehman Aggregate; and 12% NCREIF. A third party
investment consultant tracks the plan's portfolio relative to the benchmark and
provides quarterly investment reviews which consist of a performance and risk
assessment on all investment managers and on the portfolio.
Certain managers within the plan use, or have authorization to use,
derivative financial instruments for risk management purposes or as a part of
their investment strategy. Currency hedges have also been used for defensive
purposes. Leverage is used by real estate managers but is limited by investment
policy.
The policy for the UES pension plan is to provide exposures to equity and
debt securities by investing in a balanced fund. As of December 31, 2004, the
fund had approximately 60% of its assets invested in stocks and 40% in fixed
income securities. The fund will hold no more than 75% of its total assets in
stocks.
CONTRIBUTIONS
TEP expects to contribute $6 million to its pension plans in 2005 and UES
expects to contribute $1 million.
K-136
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
ESTIMATED FUTURE BENEFIT PAYMENTS
The following benefit payments, which reflect future service, as
appropriate, are expected to be paid:
PENSION OTHER
BENEFITS BENEFITS
- -----------------------------------------------------
-Millions of Dollars-
2005 $ 4 $ 3
2006 5 4
2007 6 4
2008 7 5
2009 8 6
Years 2010-2014 56 34
DEFINED CONTRIBUTION PLANS
TEP and UES sponsor defined contribution savings plans that are offered to
all eligible employees. Certain affiliate employees are also eligible to
participate. The plans are qualified 401(k) plans under the Internal Revenue
Code. In a defined contribution plan, the benefits a participant is to receive
result from regular contributions to a participant account. Participants direct
the investment of contributions to certain funds in their account. Matching
contributions to participant accounts are made under these plans. Matching
contributions to these plans were approximately $4 million in 2004 and $3
million in each of 2003 and 2002.
NOTE 17. STOCK-BASED COMPENSATION PLANS
- ----------------------------------------
Through December 31, 2004, we accounted for UniSource Energy's two
stock-based compensation plans, the Director's Plan and the Omnibus Plan, under
the recognition and measurement principles of APB 25 as allowed under FAS 123.
However, management early adopted Statement of Financial Accounting Standards
No. 123R, Share Based Payment effective January 1, 2005. See New Accounting
Standards.
The Directors' Plan provides for annual awards of non-qualified stock
options and restricted shares or stock units to each eligible director. Under
the Directors' Plan, we are authorized to grant up to a total of 324,000 shares.
The Omnibus Plan, which expired on February 3, 2004, allowed the Compensation
Committee, a committee of non-employee directors, to grant the following types
of awards to each eligible employee: stock options; stock appreciation rights;
restricted stock; stock units; performance shares; and dividend equivalents. A
total of 4.1 million shares were previously available under the Omnibus Plan
provisions.
The terminated acquisition agreement discussed in Note 2 limited the
amount of capital stock that UniSource Energy could issue under its stock plans
in 2004. 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 did not take effect as it requires consummation of a merger to accelerate
vesting.
At December 31, 2004, we had stock options, stock units, performance
shares and restricted stock grants outstanding as discussed below.
STOCK OPTIONS
No stock options were granted during 2004. We granted stock options to key
TEP and Millennium employees and members of the Board of Directors during 2003
and 2002. All stock options were granted at exercise prices equal to the market
price of the Common Stock at the grant date. Director stock options 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.
K-137
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
A summary of the stock option activity of the Directors' Plan and Omnibus
Plan is as follows:
2004 2003 2002
- -------------------------------------------------------------------------------------------------------------------------
WEIGHTED Weighted Weighted
AVERAGE Average Average
EXERCISE Exercise Exercise
SHARES PRICE Shares Price Shares Price
- -------------------------------------------------------------------------------------------------------------------------
Options Outstanding,
Beginning of Year 2,478,551 $16.04 2,572,551 $15.77 2,071,503 $15.05
Granted - - 120,236 $17.77 590,000 $18.14
Exercised (400,003) $15.29 (199,400) $13.72 (64,851) $14.42
Forfeited (2,996) $13.66 (14,836) $14.20 (24,101) $15.43
------------ ------------ -----------
Options Outstanding,
End of Year 2,075,552 $16.19 2,478,551 $16.04 2,572,551 $15.77
============ ============ ===========
Options Exercisable,
End of Year 2,053,281 $16.17 1,676,803 $15.27 1,441,829 $14.47
Exercise Price Range of Options Outstanding at December 31, 2004: $11.00 to $18.84
Weighted Average Remaining Contractual Life at December 31, 2004: 5.68 years
- -------------------------------------------------------------------------------------------------------------------------
As discussed in Note 1, through December 31, 2004 we applied 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 Statement of
Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation
- - Transition and Disclosure.
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 2004, 2003 and 2002, we recognized compensation expense of $0.3
million for dividend equivalents on stock option grants.
RESTRICTED STOCK AND STOCK UNITS
In 2004, 2003 and 2002, we granted restricted stock awards to directors
totaling 6,480 shares, 5,157 shares and 4,644 shares, respectively. The grant
date fair value of the shares was $24.68 per share in 2004, $17.44 per share in
2003 and $19.35 per share in 2002. Directors may elect to receive stock units in
lieu of restricted shares. The restricted shares or stock units become 100%
vested on the third anniversary of the grant date. As discussed above,
Directors' awards were not affected by the shareholders' vote to approve the
proposed merger. Compensation expense equal to the fair market value on the date
of the award is recognized over the vesting period. We recorded compensation
expense of $0.1 million in 2004 and less than $0.1 million in 2003 and 2002
related to these awards.
There were no new stock unit awards granted under the Omnibus Plan in
2004, 2003 or 2002. When prior awards were granted, compensation expense equal
to the fair market value on the date of the award was recognized over a three or
four year vesting period. All stock unit awards under the Omnibus Plan were
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 $1 million in each of the last three years.
Fully vested but undistributed stock unit awards accrue dividend
equivalent stock units based on the fair market value of common shares on the
date the dividend is paid. Compensation expense is recognized when dividends are
declared. We recorded compensation expense of $0.2 million in 2004 and 2003 for
dividend equivalent stock units.
K-138
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
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 recorded
over 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. Compensation expense of $0.7 million was recorded in 2003 for this
award.
NOTE 18. UNISOURCE ENERGY EARNINGS PER SHARE (EPS)
- ---------------------------------------------------
Basic EPS is computed by dividing net income by the weighted average
number of common shares outstanding during the period. Diluted EPS assumes that
proceeds from the hypothetical exercise of stock options and other stock-based
awards are used to repurchase outstanding shares of stock at the average fair
market price during the reporting period. The numerator in calculating both
basic and diluted EPS for each period is Net Income. The following table shows
the effects of potential dilutive common stock on the weighted average number of
shares:
Years Ended December 31,
2004 2003 2002
- --------------------------------------------------------------------------------
- In Thousands-
Denominator:
Average Shares of Common Stock Outstanding 34,380 33,828 33,665
Effect of Dilutive Securities:
Warrants - - 81
Options and Stock Issuable under Employee
Benefit Plans and the Directors' Plan 661 511 476
- --------------------------------------------------------------------------------
Total Shares 35,041 34,339 34,222
================================================================================
There were no antidilutive options outstanding during the year ended
December 31, 2004. Options to purchase an average of 274,000 and 525,000 shares
of Common Stock were outstanding during the years 2003 and 2002, respectively,
but were not included in the computation of diluted EPS because the options'
exercise price was greater than the average market price of the common stock.
At December 31, 2004, UniSource Energy had no outstanding warrants. There
were 4.6 million warrants that were exercisable into TEP common stock until
December 15, 2002, when they expired. The dilutive effect of these warrants was
the same as it would have been if the warrants were exercisable into UniSource
Energy Common Stock.
NOTE 19. RELATED PARTIES
- -------------------------
UniSource Energy incurs corporate costs that are allocated to TEP and its
other affiliates. Certain corporate costs are directly assigned to TEP. Other
corporate costs are allocated based on a weighted-average residual allocation
factor. Management believes this method of allocation is reasonable and
approximates the cost that TEP and its other affiliates would have incurred as
stand-alone entities. Charges allocated to TEP were $12 million in 2004, $5
million in 2003 and $3 million in 2002.
TEP provides all corporate services (finance, accounting, tax, information
technology services, etc.) to UniSource Energy, UNS Gas and UNS Electric as well
as to UniSource Energy's non-utility businesses. Costs are directly assigned to
the benefiting entity where possible. Common costs are allocated on a
transaction-oriented basis. Management believes this method of allocation is
reasonable. The charges by TEP were $7 million in 2004, $5 million in 2003 and
$2 million in 2002.
Southwest Energy Solutions, Inc. (SES), a subsidiary of Millennium,
provides a supplemental workforce for TEP. Types of services provided for TEP
are dusk to dawn lighting, facilities maintenance, meter reading, solar work,
transmission and distribution, and general supplemental support. SES bills TEP
K-139
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
for providing these services. Management believes that the charges for services
are reasonable and approximates the cost that TEP would have incurred if it
performed these services directly. The charges to TEP for these services were
$13 million in 2004, $8 million in 2003 and $8 million in 2002.
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 owns 31% of Haddington and accounts for this
investment under the equity method.
Valley Ventures III, LP (Valley Ventures) is a venture capital fund that
invests in information technology, microelectronics and biotechnology, primarily
within the southwestern U.S. Another member of the UniSource Energy Board of
Directors is a general partner of the company that manages the fund. Millennium
owns 15% of the fund and accounts for this investment under the equity method
due to an ability to exercise significant influence over the fund based on the
related party disclosure above.
Carboelectrica Sabinas, S. de R.L. de C.V. (Sabinas) is a Mexican
limited liability company created to develop up to 800 megawatts (MW) of
coal-fired generation in the Sabinas region of Coahuila, Mexico. 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 a member of the board of directors of AHMSA. As of December 31, 2004,
Millennium's investment in Sabinas is approximately $19 million. Millennium
accounts for the investment in Sabinas under the cost method.
K-140
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
NOTE 20. SUPPLEMENTAL CASH FLOW INFORMATION
- --------------------------------------------
A reconciliation of net income to net cash flows from operating activities
follows:
UNISOURCE ENERGY
----------------------------------------------
Years Ended December 31,
2004 2003 2002
----------------------------------------------
-Thousands of Dollars-
NET INCOME $45,919 $113,941 $ 34,928
ADJUSTMENTS TO RECONCILE NET INCOME
TO NET CASH FLOWS FROM OPERATING ACTIVITIES
Cumulative Effect of Accounting Change-Net of Tax - (67,471) -
Depreciation and Amortization Expense 135,315 130,643 127,923
Depreciation Recorded to Fuel and Other O&M Expense 6,175 6,230 5,701
Coal Contract Amendment Fee - - (14,248)
Amortization of Transition Recovery Asset 50,153 31,752 24,489
Net Unrealized (Gain) Loss on TEP Forward Electric Sales (1,509) 761 1,302
Net Unrealized Loss (Gain) on TEP Forward Electric Purchases 250 (378) (1,835)
Net Unrealized Gain on MEG Trading Activities (551) (1,046) (188)
Amortization of Deferred Debt-Related Costs included in
Interest Expense 5,413 2,972 2,058
Provision for Bad Debts 2,821 4,820 1,688
Deferred Income Taxes 5,303 (3,002) (8,694)
(Gain) Loss from Equity Method Investment Entities (7,326) 2,984 3,560
Gain on Sale of Real Estate (725) (467) -
Other (10,981) 46,052 (13,953)
Changes in Assets and Liabilities which Provided (Used)
Cash Exclusive of Changes Shown Separately
Accounts Receivable (13,927) (18,622) 37,591
Materials and Fuel Inventory (3,926) (7,412) (2,118)
Accounts Payable 29,531 (7,944) (35,193)
Interest Accrued 9,890 13,151 18,542
Taxes Accrued 15,684 10,353 (8,331)
Other Current Assets (49,781) (7,011) (12,199)
Other Current Liabilities 53,396 12,688 5,991
Other Deferred Credits and Other Liabilities 18,815 17,442 9,423
Deposit - Second Mortgage Indenture 17,040 (17,040) -
- ----------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES $306,979 $263,396 $176,437
======================================================================================================================
K-141
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
TEP
----------------------------------------------
Years Ended December 31,
2004 2003 2002
- -------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
NET INCOME $ 46,127 $ 128,913 $ 55,390
ADJUSTMENTS TO RECONCILE NET INCOME
TO NET CASH FLOWS FROM OPERATING ACTIVITIES
Cumulative Effect of Accounting Change-Net of Tax - (67,471) -
Depreciation and Amortization Expense 117,109 121,037 124,054
Depreciation Recorded to Fuel and Other O&M Expense 6,175 6,230 5,701
Coal Contract Amendment Fee - - (14,248)
Amortization of Transition Recovery Asset 50,153 31,752 24,489
Net Unrealized (Gain) Loss on Forward Electric Sales (1,509) 761 1,302
Net Unrealized Loss (Gain) on Forward Electric Purchases 250 (378) (1,835)
Amortization of Deferred Debt-Related Costs included in
Interest Expense 5,104 2,921 2,058
Provision for Bad Debts 1,691 4,460 1,688
Deferred Income Taxes (1,011) 1,136 5,522
(Gains) Losses from Equity Method Investment Entities (168) (142) 530
Interest Accrued on Note Receivable from UniSource Energy (9,329) (10,242) (9,329)
Gain on Sale of Real Estate (725) (467) -
Other (3,219) 15,927 (250)
Changes in Assets and Liabilities which Provided (Used)
Cash Exclusive of Changes Shown Separately
Accounts Receivable (23,774) (8,717) 32,318
Materials and Fuel Inventory (1,100) (5,607) (1,331)
Accounts Payable 24,958 8,225 (35,011)
Interest Accrued 10,264 28,576 18,542
Taxes Accrued 20,031 1,281 (3,663)
Other Current Assets (5,328) 581 (12,771)
Other Current Liabilities 4,790 1,468 6,157
Other Deferred Credits and Other Liabilities 17,622 17,785 7,678
Deposit - Second Mortgage Indenture 17,040 (17,040) -
- --------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES $275,151 $ 260,989 $206,991
====================================================================================================================
Non-cash investing and financing activities of UniSource Energy and TEP
that affected recognized assets and liabilities but did not result in cash
receipts or payments were as follows:
Years Ended December 31,
2004 2003 2002
- ------------------------------------------------------------------------
-Thousands of Dollars-
Capital Lease Obligations $ 12,273 $ 10,731 $ 11,604
- ------------------------------------------------------------------------
The non-cash change in capital lease obligations represents interest
accrued for accounting purposes in excess of interest payments in 2004, 2003,
and 2002.
On August 11, 2003, UniSource Energy acquired the Arizona gas and
electric system assets from Citizens for $223 million, comprised of the base
purchase price plus other operating capital adjustments and transaction costs.
In conjunction with the acquisition, liabilities were assumed as follows:
K-142
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
- --------------------------------------------------------------------------------
- Thousands of Dollars -
- --------------------------------------------------------------------
Fair Value of Assets Acquired $262,044
Liabilities Assumed 38,648
- --------------------------------------------------------------------
Assets/Liabilities Purchased $223,396
====================================================================
Cash Paid for Citizens Assets $218,558
Transaction Costs 4,838
- --------------------------------------------------------------------
Total Purchase Price $223,396
====================================================================
NOTE 21. QUARTERLY FINANCIAL DATA (UNAUDITED)
- ----------------------------------------------
Our quarterly financial information has not been audited but, in
management's opinion, includes all adjustments necessary for a fair
presentation. Our utility businesses are seasonal in nature with peak sales
periods for TEP and UNS Electric generally occurring during the summer months
and peak sales periods for UNS Gas generally occurring during the winter months.
Accordingly, comparisons among quarters of a year may not represent overall
trends and changes in operations.
UNISOURCE ENERGY
-------------------------------------------------------------
FIRST SECOND THIRD FOURTH
-------------------------------------------------------------
-Thousands of Dollars-
(except per share data)
2004
Operating Revenue $270,084 $290,081 $335,309 $273,504
Operating Income 42,710 61,571 75,461 39,648
Net Income 6,421 12,801 23,799 2,898
Basic EPS $0.19 $0.37 $0.69 $0.08
Diluted EPS $0.18 $0.37 $0.68 $0.08
2003
Operating Revenue $172,247 $216,073 $304,252 $280,183
Operating Income 12,069 46,981 83,719 60,236
Income (Loss) Before Cumulative Effect of Accounting Change (15,125) 6,920 27,376 27,299
Cumulative Effect of Accounting Change - Net of Tax 67,471 - - -
Net Income 52,346 6,920 27,376 27,299
Basic EPS:
- ----------
Income (Loss) Before Cumulative Effect of Accounting Change $(0.45) $0.20 $0.81 $0.81
Cumulative Effect of Accounting Change - Net of Tax 2.00 - - -
Net Income 1.55 0.20 0.81 0.81
Diluted EPS:
- ------------
Income (Loss) Before Cumulative Effect of Accounting Change (0.45) 0.20 0.80 0.79
Cumulative Effect of Accounting Change - Net of Tax 2.00 - - -
Net Income 1.55 0.20 0.80 0.79
K-143
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONCLUDED)
TEP
-------------------------------------------------------------
FIRST SECOND THIRD FOURTH
-------------------------------------------------------------
-Thousands of Dollars-
2004
Operating Revenue $186,974 $233,742 $272,085 $196,497
Operating Income 35,688 62,269 74,531 34,196
Interest Income - Note Receivable from UniSource Energy 2,320 2,319 2,345 2,345
Net Income 794 18,017 26,222 1,094
2003
Operating Revenues $171,627 $214,688 $265,871 $199,365
Operating Income 19,641 55,825 87,015 48,517
Interest Income - Note Receivable from UniSource Energy 2,525 2,554 2,581 2,582
Income (Loss) Before Cumulative Effect of Accounting Change (8,100) 13,511 32,194 23,837
Cumulative Effect of Accounting Change - Net of Tax 67,471 - - -
Net Income 59,371 13,511 32,194 23,837
EPS is computed independently for each of the quarters presented. Therefore, the
sum of the quarterly EPS amounts may not equal the total for the year.
The principal unusual items for TEP and UniSource Energy include:
TEP AND UNISOURCE ENERGY
o FOURTH QUARTER 2004: UniSource Energy recorded a $7 million
pre-tax acquisition termination fee of which 77% was allocated to
TEP. See Note 2. UniSource Energy recognized a current income tax
benefit of $1.1 million as a result of deducting certain
acquisition-related legal and advisory fees that had previously
been treated as permanently nondeductible expenses, 77% of which
was recognized by TEP. TEP recorded a $2 million pre-tax net
cumulative reduction of previously overstated depreciation and
interest expense related to a capitalized lease transaction. See
Notes 9 and 10. TEP recognized a $1 million income tax expense due to
the uncertainty of future use of certain ITC carryforwards. See Note
15.
o FIRST QUARTER 2003: TEP recorded an after-tax gain of $67 million
for the cumulative effect of adopting FAS 143. See Note 5.
o FOURTH QUARTER 2003: TEP recognized a $15 million tax benefit due
to a reduction in its NOL valuation allowance. See Note 15.
UniSource Energy recorded $3 million of acquisition-related fees,
80% of which were allocated to TEP. These fees did not result in
a current tax deduction. See Note 15.
UNISOURCE ENERGY
o FIRST QUARTER 2004: MEH recognized a $3.1 million after-tax gain
from the sale of Sago Energy, LP's operating subsidiaries, a
Haddington investment.
o FOURTH QUARTER 2003: UED recognized an $11 million pre-tax
development fee for closing the Springerville expansion project.
See Note 14. This quarter also includes the first full quarter of
activity for UES which was established on August 11, 2003. UES
contributed Operating Revenues of $69 million, Operating Income
of $7 million and Net Income of $3 million to fourth quarter
results.
K-144
UNISOURCE ENERGY
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
ADDITIONS-
BEGINNING CHARGED TO ENDING
DESCRIPTION BALANCE INCOME DEDUCTIONS BALANCE
- --------------------------------------------------------------------------------------------
Year Ended December 31, -Millions of Dollars-
Deferred Tax Assets Valuation Allowance (1)
2004 $ 7 $ 1 $ - $ 8
2003 22 - 15 7
2002 16 7 1 22
Allowance for Doubtful Accounts (2)
2004 $ 12 $ 7 $ 2 $ 17
2003 9 5 2 12
2002 9 2 2 9
- --------------------------------------------------------------------------------------------
(1) The deferred tax assets valuation allowance reduces the deferred tax asset
balance. It relates to NOL and ITC carryforward amounts. UniSource, TEP and
Subsidiaries charged $1 million to income in 2004 related to TEP's ITC
carryforwards that may not be utilized prior to their expiration. UniSource, TEP
and Subsidiaries reduced the deferred tax assets valuation in 2003 primarily
based on guidance issued by the Internal Revenue Service in September, 2003 (see
Note 15 of Notes to Consolidated Financial Statements). UniSource, TEP and
Subsidiaries charged approximately $7 million to income in 2002 relating to the
limitation on the utilization of operating losses generated by certain
Millennium entities. UniSource, TEP and Subsidiaries reduced the deferred tax
assets valuation in 2002 due to the settlement of Internal Revenue Service
audits.
(2) TEP and UES record additions to the Allowance for Doubtful accounts based on
historical experience and any specific customer collection issues identified.
Deductions principally reflect amounts charged off as uncollectible, less
amounts recovered. Balances related primarily to TEP reserves for sales to the
CPX and CISO in 2000 and 2001. See Note 13 of Notes to Consolidated Financial
Statements.
K-145
TEP
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
ADDITIONS-
BEGINNING CHARGED TO ENDING
DESCRIPTION BALANCE INCOME DEDUCTIONS BALANCE
- --------------------------------------------------------------------------------------------
Year Ended December 31, -Millions of Dollars-
Deferred Tax Assets Valuation Allowance (1)
2004 $ - $ 1 $ - $ 1
2003 15 - 15 -
2002 16 - 1 15
Allowance for Doubtful Accounts (2)
2004 $11 $ 5 $ 2 $ 14
2003 9 5 3 11
2002 9 2 2 9
- -------------------------------------------------------------------------------------------
(1) The deferred tax assets valuation allowance reduces the deferred tax asset
balance. It relates to NOL and ITC carryforward amounts. TEP charged $1 million
to income in 2004 related to ITC carryforwards that may not be utilized prior to
their expiration. TEP reduced the deferred tax assets valuation in 2003
primarily based on guidance issued by the Internal Revenue Service in September,
2003 (see Note 15 of Notes to Consolidated Financial Statements). TEP reduced
the deferred tax assets valuation in 2002 due to the settlement of Internal
Revenue Service audits.
(2) TEP recorded $7 million of expense in the first quarter of 2001 and $9
million in the fourth quarter of 2000 to reserve for uncollectible amounts
related to sales to the state of California in 2000 and the first quarter of
2001. TEP reversed $8 million of the $16 million reserve in the fourth quarter
of 2001. In the first quarter of 2003, TEP increased its reserve for sales to
the CPX and the CISO by $2 million by recording a reduction of wholesale
revenues. In the second quarter of 2004, TEP increased its reserve for sales to
the CPX and the CISO by an additional $3 million based on new FERC orders.
Deductions principally reflect amounts charged off as uncollectible, less
amounts recovered (see Note 13 of Notes to Consolidated Financial Statements).
K-146
ITEM 9. - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
- --------------------------------------------------------------------------------
None.
ITEM 9A. - CONTROLS AND PROCEDURES
- --------------------------------------------------------------------------------
UniSource Energy and TEP's Chief Executive Officer and Chief Financial
Officer supervised and participated in UniSource Energy and TEP's evaluation of
their disclosure controls and procedures as of December 31, 2004. Disclosure
controls and procedures are controls and procedures designed to ensure that
information required to be disclosed in UniSource Energy and TEP's periodic
reports filed or submitted under the Securities Exchange Act of 1934, as
amended, is recorded, processed, summarized and reported within the time periods
specified in the Securities and Exchange Commission's rules and forms. These
disclosure controls and procedures can only provide reasonable, not absolute,
assurance that the above objectives have been met. Based upon the evaluation
performed, UniSource Energy and TEP's Chief Executive Officer and Chief
Financial Officer concluded that UniSource Energy and TEP's disclosure controls
and procedures are effective.
While UniSource Energy and TEP continually strive to improve their
disclosure controls and procedures to enhance the quality of their financial
reporting, there has been no change in UniSource Energy or TEP's internal
control over financial reporting during the fourth quarter of 2004, that has
materially affected, or is reasonably likely to materially affect, UniSource
Energy or TEP's internal control over financial reporting.
UniSource Energy's Management's Report on Internal Control Over Financial
Reporting Under 404 of Sarbanes-Oxley appears as the first report under Item 8
and the Report of Independent Registered Public Accounting Firm appears as the
second report under Item 8 in this Annual Report on Form 10-K.
ITEM 9B. - OTHER INFORMATION
- --------------------------------------------------------------------------------
In December 1998, TEP entered into change in control agreements (the
"Agreements") with all of the officers of TEP. As of March 1, 2005, the
Agreements were in effect with respect to the following officers: Thomas A.
Delawder, Michael DeConcini, Steven J. Glaser, Thomas N. Hansen, Karen G.
Kissinger, Kevin P. Larson, Steven W. Lynn, Dennis R. Nelson, Vincent Nitido Jr.
and James S. Pignatelli.
The Agreements provide that each officer shall be employed by TEP, or one
of its subsidiaries or affiliates, in a position comparable to his or her
current position, with compensation and benefits, which are at least equal to
their then current compensation and benefits, for a period of five years after a
change in control (subject to earlier termination due to the officer's
acceptance of a position with another company or termination for cause). In the
event that the officer's employment is terminated by TEP (with the exception of
termination due to the officer's acceptance of another position or for cause),
or if the officer terminates employment because of a reduction in position,
responsibility, compensation or for certain other stated reasons, the officer is
entitled to certain severance benefits. Under the terms of the Agreements, the
approval by UniSource Energy's shareholders at the March 29, 2004 special
meeting of the proposed acquisition of all of UniSource Energy's outstanding
Common Stock by Saguaro constituted a change of control.
On March 3, 2005, TEP provided the officers with respect to which the
Agreements were in effect at that time, written notice of the termination of the
Agreements. Pursuant to the terms of the Agreements, the termination will become
effective on March 3, 2010, the fifth anniversary of the date of the written
notice of termination.
ITEM 10. - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS
- --------------------------------------------------------------------------------
DIRECTORS
---------
Certain of the individuals serving as Directors of UniSource Energy also
serve as the Directors of TEP. Information concerning Directors will be
contained under Election of Directors in UniSource Energy's Proxy Statement
relating to the 2005 Annual Meeting of Shareholders, which will be filed with
the SEC not later than 120 days after December 31, 2004, which information is
incorporated herein by reference.
EXECUTIVE OFFICERS - UNISOURCE ENERGY
-------------------------------------
Executive Officers of UniSource Energy, who are elected annually by
UniSource Energy's Board of Directors, are as follows:
EXECUTIVE
OFFICER
NAME AGE POSITION(S) HELD SINCE
- --------------------------------------------------------------------------------
James S. Pignatelli 61 Chairman, President and
Chief Executive Officer 1998
Michael J. DeConcini 40 Senior Vice President, Investments
and Planning 1999
Dennis R. Nelson 54 Senior Vice President, Utility
Services 1998
Karen G. Kissinger 50 Vice President, Controller and
Chief Compliance Officer 1998
Kevin P. Larson 48 Vice President, Chief Financial
Officer and Treasurer 2000
Steven W. Lynn 58 Vice President, Communications
and Government Relations 2003
Vincent Nitido, Jr. 49 Vice President, General Counsel
and Chief Administrative Officer 2000
Catherine A. Nichols 46 Corporate Secretary 2003
- --------------------------------------------------------------------------------
K-147
JAMES S. PIGNATELLI Mr. Pignatelli joined TEP as Senior Vice President
in August 1994 and was elected Senior Vice President
and Chief Operating Officer in 1996. He was named
Senior Vice President and Chief Operating Officer of
UniSource Energy in January 1998, and Executive Vice
President and Chief Operating Officer of TEP in
March 1998. On June 23, 1998, Mr. Pignatelli was
named Chairman, President and CEO of UniSource
Energy and TEP. Prior to joining TEP, he was
President and Chief Executive Officer from 1988 to
1993 of Mission Energy Company, a subsidiary of SCE
Corp.
MICHAEL J. DECONCINI Mr. DeConcini joined TEP in 1988 and served in
various positions in finance, strategic planning and
wholesale marketing. He was Manager of TEP's
Wholesale Marketing Department in 1994, adding
Product Development and Business Development in
1997. In November 1998, he was elected Vice
President of MEH, and elected Vice President,
Strategic Planning of UniSource Energy in February
1999. He was named Senior Vice President,
Investments and Planning of UniSource Energy in
October 2000. Mr. DeConcini was elected Senior Vice
President and Chief Operating Officer of the Energy
Resources business unit of TEP, effective January 1,
2003.
DENNIS R. NELSON Mr. Nelson joined TEP as a staff attorney in 1976.
He was manager of the Legal Department from 1985 to
1990. He was elected Vice President, General Counsel
and Corporate Secretary in January 1991. He was
named Vice President, General Counsel and Corporate
Secretary of UniSource Energy in January 1998. Mr.
Nelson was named Senior Vice President and General
Counsel of TEP in November 1998. In December 1998,
he was named Chief Operating Officer, Corporate
Services of TEP. In October 2000, he was named
Senior Vice President, Governmental Affairs of
UniSource Energy and Senior Vice President and Chief
Operating Officer of the Energy Resources business
unit of TEP. Mr. Nelson was elected Senior Vice
President of Utility Services, effective January 1,
2003 and named Chief Operating Officer of UES on
August 11, 2003.
KAREN G. KISSINGER Ms. Kissinger joined TEP as Vice President and
Controller in January 1991. She was named Vice
President, Controller and Principal Accounting
Officer of UniSource Energy in January 1998. In
November 1998, Ms. Kissinger was also named Chief
Information Officer of TEP. She was named Chief
Compliance Officer of UniSource Energy and TEP,
effective January 1, 2003.
KEVIN P. LARSON Mr. Larson joined TEP in 1985 and thereafter held
various positions in its finance department and at
TEP's investment subsidiaries. In January 1991, he
was elected Assistant Treasurer of TEP and named
Manager of Financial Programs. He was elected
Treasurer of TEP in August 1994 and Vice President
in March 1997. In October 2000, he was elected Vice
President and Chief Financial Officer of both
UniSource Energy and TEP and remains Treasurer of
both organizations.
STEVEN W. LYNN Mr. Lynn joined TEP in 2000 as Manager of Corporate
Relations for UniSource Energy and was named Manager
of Corporate Relations of both TEP and UniSource
Energy during 2000. In January 2003, he was elected
Vice President of Communications and Government
Relations at UniSource Energy and TEP. Prior to
joining TEP, Mr. Lynn was an owner-partner from 1984
- 2000 of Nordensson Lynn & Associates, Inc., a
Tucson-based advertising, marketing and public
relations firm.
VINCENT NITIDO, JR. Mr. Nitido joined TEP as a staff attorney in 1991.
He was promoted to Manager of the Legal Department
in 1994, and elected Vice President and Assistant
General Counsel in 1998. In October 2000, he was
elected Vice President, General Counsel of both
UniSource Energy and TEP and Corporate Secretary of
UniSource Energy. Mr. Nitido was also named Chief
Administrative Officer of UniSource Energy and TEP,
effective January 1, 2003.
CATHERINE A. NICHOLS Ms. Nichols joined TEP as a staff attorney in 1989.
She was promoted to Manager of the Legal Department
and elected Corporate Secretary of TEP in 1998. She
assumed the additional role of Manager of the Human
Resources Department in 1999. Ms. Nichols was
elected Corporate Secretary of UniSource Energy,
effective January 1, 2003, and remains Corporate
Secretary of TEP.
K-148
EXECUTIVE OFFICERS - TUCSON ELECTRIC POWER COMPANY
--------------------------------------------------
Executive Officers of TEP, who are elected annually by TEP's Board of
Directors, are:
EXECUTIVE
OFFICER
NAME AGE POSITION(S) HELD SINCE
- --------------------------------------------------------------------------------
James S. Pignatelli 61 Chairman, President and
Chief Executive Officer 1994
Michael J. DeConcini 40 Senior Vice President, Energy
Resources Business Unit 2003
Steven J. Glaser 47 Senior Vice President and
Chief Operating Officer,
Transmission and Distribution
Business Unit 1994
Thomas A. Delawder 58 Vice President, Energy Resources
Business Unit 1985
Thomas N. Hansen 54 Vice President / Technical Advisor 1992
Karen G. Kissinger 50 Vice President, Controller and Chief
Compliance Officer 1991
Kevin P. Larson 48 Vice President, Chief Financial
Officer and Treasurer 1994
Steven W. Lynn 58 Vice President, Communications and
Government Relations 2003
Vincent Nitido, Jr. 49 Vice President, General Counsel
and Chief Administrative Officer 1998
Catherine A. Nichols 46 Corporate Secretary 1998
- --------------------------------------------------------------------------------
JAMES S. PIGNATELLI See description shown under UniSource Energy
Corporation above.
MICHAEL J. DECONCINI See description shown under UniSource Energy
Corporation above.
STEVEN J. GLASER Mr. Glaser joined TEP in 1990 as a Senior Attorney
in charge of Regulatory Affairs. He was Manager of
TEP's Legal Department from 1992 to 1994, and
Manager of Contracts and Wholesale Marketing from
1994 until elected Vice President, Business
Development. In 1995, he was named Vice President,
Wholesale/Retail Pricing and System Planning. He was
named Vice President, Energy Services in 1996 and
Vice President, Rates and Regulatory Support and
Utility Distribution Company Energy Services in
November 1998. In October 2000, he was named Senior
Vice President and Chief Operating Officer of the
Transmission and Distribution business unit.
THOMAS A. DELAWDER Mr. Delawder joined TEP in 1974 and thereafter
served in various engineering and operations
positions. In April 1985, he was named Manager,
Systems Operations and was elected Vice President,
Power Supply and System Control in November 1985. In
February 1991, he became Vice President, Engineering
and Power Supply and in January 1992 he became Vice
President, System Operations. In 1994, he became
Vice President of the Energy Resources business
unit. Mr. Delawder has submitted his intent to
retire, after 30 years of service, effective April
1, 2005.
THOMAS N. HANSEN Mr. Hansen joined TEP in December 1992 as Vice
President, Power Production. Prior to joining TEP,
Mr. Hansen was Century Power Corporation's Vice
President, Operations from 1989 and Plant Manager at
Springerville from 1987 through 1988. In 1994, he
was named Vice President / Technical Advisor.
KAREN G. KISSINGER See description shown under UniSource Energy
Corporation above.
KEVIN P. LARSON See description shown under UniSource Energy
Corporation above.
STEVEN W. LYNN See description shown under UniSource Energy
Corporation above.
VINCENT NITIDO, JR. See description shown under UniSource Energy
Corporation above.
CATHERINE A. NICHOLS See description shown under UniSource Energy
Corporation above.
Information required by Items 405 and 406 of SEC Regulation S-K will be
included in UniSource Energy's Proxy Statement relating to the 2005 Annual
Meeting of Shareholders, which will be filed with the SEC not later than 120
days after December 31, 2004, which information is incorporated herein by
reference.
K-149
ITEM 11. - EXECUTIVE COMPENSATION
- --------------------------------------------------------------------------------
Information concerning Executive Compensation will be contained under
Executive Compensation and Other Information in UniSource Energy's Proxy
Statement relating to the 2005 Annual Meeting of Shareholders, which will be
filed with the SEC not later than 120 days after December 31, 2004, which
information is incorporated herein by reference.
ITEM 12. - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
- --------------------------------------------------------------------------------
GENERAL
At March 11, 2005, UniSource Energy had outstanding 34.5 million shares of
Common Stock. As of March 11, 2005, the number of shares of Common Stock
beneficially owned by all directors and officers of UniSource Energy as a group
amounted to approximately 6% of the outstanding Common Stock.
At March 11, 2005, UniSource Energy owned greater than 99.9% of the
outstanding shares of common stock of TEP.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
Information concerning the security ownership of certain beneficial owners
of UniSource Energy will be contained under Security Ownership of Certain
Beneficial Owners in UniSource Energy's Proxy Statement relating to the 2005
Annual Meeting of Shareholders, which will be filed with the SEC not later than
120 days after December 31, 2004, which information is incorporated herein by
reference.
SECURITY OWNERSHIP OF MANAGEMENT
Information concerning the security ownership of the Directors and
Executive Officers of UniSource Energy and TEP will be contained under Security
Ownership of Management in UniSource Energy's Proxy Statement relating to the
2005 Annual Meeting of Shareholders, which will be filed with the SEC not later
than 120 days after December 31, 2004, which information is incorporated herein
by reference.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
Information concerning securities authorized for issuance under equity
compensation plans will be contained under Securities Authorized for Issuance
under Equity Compensation Plans in UniSource Energy's Proxy Statement relating
to the 2005 Annual Meeting of Shareholders, which will be filed with the SEC not
later than 120 days after December 31, 2004, which information is incorporated
herein by reference.
ITEM 13. - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
- --------------------------------------------------------------------------------
Information concerning certain relationships and related transactions of
UniSource Energy and TEP will be contained under Transactions with Management
and Others and Compensation Committee Interlocks and Insider Participation in
UniSource Energy's Proxy Statement relating to the 2005 Annual Meeting of
Shareholders, which will be filed with the SEC not later than 120 days after
December 31, 2004, which information is incorporated herein by reference.
ITEM 14. - PRINCIPAL ACCOUNTANT FEES AND SERVICES
- --------------------------------------------------------------------------------
Information concerning principal accountant fees and services will be
contained in UniSource Energy's Proxy Statement relating to the 2005 Annual
Meeting of Shareholders, which will be filed with the SEC not later than 120
days after December 31, 2004, which information is incorporated herein by
reference.
K-150
PART IV
ITEM 15. - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
- --------------------------------------------------------------------------------
Page
----
(a) 1. Consolidated Financial Statements as of December 31, 2004
and 2003 and for Each of the Three Years in the Period
Ended December 31, 2004
UNISOURCE ENERGY CORPORATION
Report of Independent Registered Public Accounting Firm 69
Consolidated Statements of Income 70
Consolidated Statements of Cash Flows 71
Consolidated Balance Sheets 72
Consolidated Statements of Capitalization 73
Consolidated Statements of Changes in Stockholders' Equity 74
Notes to Consolidated Financial Statements 80
TUCSON ELECTRIC POWER COMPANY
Report of Independent Registered Public Accounting Firm 69
Consolidated Statements of Income 75
Consolidated Statements of Cash Flows 76
Consolidated Balance Sheets 77
Consolidated Statements of Capitalization 78
Consolidated Statements of Changes in Stockholders' Equity 79
Notes to Consolidated Financial Statements 80
2. Financial Statement Schedule
Schedule II
Valuation and Qualifying Accounts 133
3. Exhibits
Reference is made to the Exhibit Index commencing on page 144.
K-151
SIGNATURES
Pursuant to the requirements of Section 13 and 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
UNISOURCE ENERGY CORPORATION
Date: March 16, 2005 By: /s/ Kevin P. Larson
-----------------------------------------
Kevin P. Larson
Vice President and Principal
Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Date: March 16, 2005 /s/ James S. Pignatelli*
-----------------------------------------
James S. Pignatelli
Chairman of the Board, President
and Principal Executive Officer
Date: March 16, 2005 /s/ Kevin P. Larson
-----------------------------------------
Kevin P. Larson
Principal Financial Officer
Date: March 16, 2005 /s/ Karen G. Kissinger*
-----------------------------------------
Karen G. Kissinger
Principal Accounting Officer
Date: March 16, 2005 /s/ Lawrence J. Aldrich*
-----------------------------------------
Lawrence J. Aldrich
Director
Date: March 16, 2005 /s/ Larry W. Bickle*
-----------------------------------------
Larry W. Bickle
Director
Date: March 16, 2005 /s/ Elizabeth T. Bilby*
-----------------------------------------
Elizabeth T. Bilby
Director
Date: March 16, 2005 /s/ Harold W. Burlingame*
-----------------------------------------
Harold W. Burlingame
Director
Date: March 16, 2005 /s/ John L. Carter*
-----------------------------------------
John L. Carter
Director
Date: March 16, 2005 /s/ Robert A. Elliott*
-----------------------------------------
Robert A. Elliott
Director
K-152
Date: March 16, 2005 /s/ Kenneth Handy*
-----------------------------------------
Kenneth Handy
Director
Date: March 16, 2005 /s/ Warren Y. Jobe*
-----------------------------------------
Warren Y. Jobe
Director
Date: March 16, 2005 * By: /s/ Kevin P. Larson
-----------------------------------------
Kevin P. Larson
As attorney-in-fact for each
of the persons indicated
K-153
SIGNATURES
----------
Pursuant to the requirements of Section 13 and 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
TUCSON ELECTRIC POWER COMPANY
Date: March 16, 2005 By: /s/ Kevin P. Larson
-----------------------------------------
Kevin P. Larson
Vice President and Principal
Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Date: March 16, 2005 /s/ James S. Pignatelli*
-----------------------------------------
James S. Pignatelli
Chairman of the Board, President
and Principal Executive Officer
Date: March 16, 2005 /s/ Kevin P. Larson
-----------------------------------------
Kevin P. Larson
Principal Financial Officer
Date: March 16, 2005 /s/ Karen G. Kissinger*
-----------------------------------------
Karen G. Kissinger
Principal Accounting Officer
Date: March 16, 2005 /s/ Lawrence J. Aldrich*
-----------------------------------------
Lawrence J. Aldrich
Director
Date: March 16, 2005 /s/ Elizabeth T. Bilby*
-----------------------------------------
Elizabeth T. Bilby
Director
Date: March 16, 2005 /s/ Harold W. Burlingame*
-----------------------------------------
Harold W. Burlingame
Director
Date: March 16, 2005 /s/ John L. Carter*
-----------------------------------------
John L. Carter
Director
Date: March 16, 2005 /s/ Robert A. Elliott*
-----------------------------------------
Robert A. Elliott
Director
K-154
Date: March 16, 2005 /s/ Kenneth Handy*
-----------------------------------------
Kenneth Handy
Director
Date: March 16, 2005 /s/ Warren Y. Jobe*
-----------------------------------------
Warren Y. Jobe
Director
Date: March 16, 2005 * By: /s/ Kevin P. Larson
-----------------------------------------
Kevin P. Larson
As attorney-in-fact for each
of the persons indicated
K-155
EXHIBIT INDEX
-------------
*2(a) -- Agreement and Plan of Exchange, dated as of March 20, 1995,
between TEP, UniSource Energy and NCR Holding, Inc.
*2(b) -- Agreement and Plan of Merger between UniSource Energy
Corporation and Saguaro Acquisition Corp., dated as of
November 21, 2003. (Form 8-K dated November 21, 2003, File
No. 1-13739 -- Exhibit 10.)
*3(a) -- Restated Articles of Incorporation of TEP, filed with the ACC on
August 11, 1994, as amended by Amendment to Article Fourth of
our Restated Articles of Incorporation, filed with the ACC on
May 17, 1996. (Form 10-K for year ended December 31, 1996,
File No. 1-5924 -- Exhibit 3(a).)
*3(b) -- Bylaws of TEP, as amended May 20, 1994. (Form 10-Q for the
quarter ended June 30, 1994, File No. 1-5924 -- Exhibit 3.)
*3(c) -- Amended and Restated Articles of Incorporation of UniSource
Energy. (Form 8-A/A, dated January 30, 1998, File No. 1-13739
-- Exhibit 2(a).)
*3(d) -- Bylaws of UniSource Energy, as amended December 11, 1997. (Form
8-A, dated December 23, 1997, File No. 1-13739 -- Exhibit 2(b).)
*4(a)(1) -- Indenture dated as of April 1, 1941, to The Chase National Bank
of the City of New York, as Trustee. (Form S-7, File No. 2-59906
-- Exhibit 2(b)(1).)
*4(a)(2) -- First Supplemental Indenture, dated as of October 1, 1946.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(2).)
*4(a)(3) -- Second Supplemental Indenture dated as of October 1, 1947.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(3).)
*4(a)(4) -- Third Supplemental Indenture, dated as of April 1, 1949. (Form
S-7, File No. 2-59906 -- Exhibit 2(b)(4).)
*4(a)(5) -- Fourth Supplemental Indenture, dated as of December 1, 1952.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(5).)
*4(a)(6) -- Fifth Supplemental Indenture, dated as of January 1, 1955.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(6).)
*4(a)(7) -- Sixth Supplemental Indenture, dated as of January 1, 1958.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(7).)
*4(a)(8) -- Seventh Supplemental Indenture, dated as of November 1, 1959.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(8).)
*4(a)(9) -- Eighth Supplemental Indenture, dated as of November 1, 1961.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(9).)
*4(a)(10) -- Ninth Supplemental Indenture, dated as of February 20, 1964.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(10).)
*4(a)(11) -- Tenth Supplemental Indenture, dated as of February 1, 1965.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(11).)
*4(a)(12) -- Eleventh Supplemental Indenture, dated as of February 1, 1966.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(12).)
K-156
*4(a)(13) -- Twelfth Supplemental Indenture, dated as of November 1, 1969.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(13).)
*4(a)(14) -- Thirteenth Supplemental Indenture, dated as of January 20, 1970.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(14).)
*4(a)(15) -- Fourteenth Supplemental Indenture, dated as of September 1, 1971.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(15).)
*4(a)(16) -- Fifteenth Supplemental Indenture, dated as of March 1, 1972.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(16).)
*4(a)(17) -- Sixteenth Supplemental Indenture, dated as of May 1, 1973. (Form
S-7, File No. 2-59906 -- Exhibit 2(b)(17).)
*4(a)(18) -- Seventeenth Supplemental Indenture, dated as of November 1, 1975.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(18).)
*4(a)(19) -- Eighteenth Supplemental Indenture, dated as of November 1, 1975.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(19).)
*4(a)(20) -- Nineteenth Supplemental Indenture, dated as of July 1, 1976.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(20).)
*4(a)(21) -- Twentieth Supplemental Indenture, dated as of October 1, 1977.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(21).)
*4(a)(22) -- Twenty-first Supplemental Indenture, dated as of November 1,
1977. (Form 10-K for year ended December 31, 1980, File No.
1-5924 -- Exhibit 4(v).)
*4(a)(23) -- Twenty-second Supplemental Indenture, dated as of January 1,
1978. (Form 10-K for year ended December 31, 1980, File No.
1-5924 -- Exhibit 4(w).)
*4(a)(24) -- Twenty-third Supplemental Indenture, dated as of July 1, 1980.
(Form 10-K for year ended December 31, 1980, File No. 1-5924 --
Exhibit 4(x).)
*4(a)(25) -- Twenty-fourth Supplemental Indenture, dated as of October 1,
1980. (Form 10-K for year ended December 31, 1980, File No.
1-5924 -- Exhibit 4(y).)
*4(a)(26) -- Twenty-fifth Supplemental Indenture, dated as of April 1, 1981.
(Form 10-Q for quarter ended March 31, 1981, File No. 1-5924 --
Exhibit 4(a).)
*4(a)(27) -- Twenty-sixth Supplemental Indenture, dated as of April 1, 1981.
(Form 10-Q for quarter ended March 31, 1981, File No. 1-5924 --
Exhibit 4(b).)
*4(a)(28) -- Twenty-seventh Supplemental Indenture, dated as of October 1,
1981. (Form 10-Q for quarter ended September 30, 1982, File No.
1-5924 -- Exhibit 4(c).)
*4(a)(29) -- Twenty-eighth Supplemental Indenture, dated as of June 1, 1990.
(Form 10-Q for quarter ended June 30, 1990, File No. 1-5924 --
Exhibit 4(a)(1).)
*4(a)(30) -- Twenty-ninth Supplemental Indenture, dated as of December 1,
1992. (Form S-1, Registration No. 33-55732 -- Exhibit 4(a)(30).)
*4(a)(31) -- Thirtieth Supplemental Indenture, dated as of December 1, 1992.
(Form S-1, Registration No. 33-55732 -- Exhibit 4(a)(31).)
*4(a)(32) -- Thirty-first Supplemental Indenture, dated as of May 1, 1996.
(Form 10-K for the year ended December 31, 1996, File No. 1-5924
-- Exhibit 4(a)(32).)
K-157
*4(a)(33) -- Thirty-second Supplemental Indenture, dated as of May 1, 1996.
(Form 10-K for the year ended December 31, 1996, File No. 1-5924
-- Exhibit 4(a)(33).)
*4(a)(34) -- Thirty-third Supplemental Indenture, dated as of May 1, 1998.
(Form 10-Q for the quarter ended June 30, 1998, File No. 1-5924
-- Exhibit 4(a).)
*4(a)(35) -- Thirty-fourth Supplemental Indenture, dated as of August 1, 1998.
(Form 10-Q for the quarter ended June 30, 1998, File No. 1-5924
-- Exhibit 4(b).)
*4(b)(1) -- Installment Sale Agreement, dated as of December 1, 1973, among
the City of Farmington, New Mexico, Public Service Company of New
Mexico and TEP. (Form 8-K for the month of January 1974, file No.
0-269 -- Exhibit 3.)
*4(b)(2) -- Ordinance No. 486, adopted December 17, 1973, of the City of
Farmington, New Mexico. (Form 8-K for the month of January 1974,
File No. 0-269 -- Exhibit 4.)
*4(b)(3) -- Amended and Restated Installment Sale Agreement dated as of April
1, 1997, between the City of Farmington, New Mexico and TEP
relating to Pollution Control Revenue bonds, 1997 Series A
(Tucson Electric Power Company San Juan Project). (Form 10-Q for
the quarter ended March 31,1997, File No. 1-5924 -- Exhibit
4(a).)
*4(b)(4) -- City of Farmington, New Mexico Ordinance No. 97-1055, adopted
April 17, 1997, authorizing Pollution Control Revenue bonds, 1997
Series A (Tucson Electric Power Company San Juan Project). (Form
10-Q for the quarter ended March 31, 1997, File No. 1-5924 --
Exhibit 4(b).)
*4(c)(1) -- Loan Agreement, dated as of October 1, 1982, between the Pima
County Authority and TEP relating to Floating Rate Monthly Demand
Industrial Development Revenue Bonds, 1982 Series A (Tucson
Electric Power Company Sundt Project). (Form 10-Q for the quarter
ended September 30, 1982, File No. 1-5924 -- Exhibit 4(a).)
*4(c)(2) -- Indenture of Trust, dated as of October 1, 1982, between the Pima
County Authority and Morgan Guaranty authorizing Floating Rate
Monthly Demand Industrial Development Revenue Bonds, 1982 Series
A (Tucson Electric Power Company Sundt Project). (Form 10-Q for
the quarter ended September 30, 1982, File No. 1-5924 -- Exhibit
4(b).)
*4(c)(3) -- First Supplemental Loan Agreement, dated as of March 31, 1992,
between the Pima County Authority and TEP relating to Industrial
Development Revenue Bonds, 1982 Series A (Tucson Electric Power
Company Sundt Project). (Form S-4, Registration No. 33-52860 --
Exhibit 4(h)(3).)
*4(c)(4) -- First Supplemental Indenture of Trust, dated as of March 31,
1992, between the Pima County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1982 Series A
(Tucson Electric Power Company Sundt Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(h)(4).)
*4(d)(1) -- Loan Agreement, dated as of December 1, 1982, between the Pima
County Authority and TEP relating to Floating Rate Monthly Demand
Industrial Development Revenue Bonds, 1982 Series A (Tucson
Electric Power Company Projects). (Form 10-K for the year ended
December 31, 1982, File No. 1-5924 -- Exhibit 4(k)(1).)
*4(d)(2) -- Indenture of Trust dated as of December 1, 1982, between the Pima
County Authority and Morgan Guaranty authorizing Floating Rate
Monthly Demand Industrial Development Revenue Bonds, 1982 Series
A (Tucson Electric Power Company Projects). (Form 10-K for the
year ended December 31, 1982, File No. 1-5924 -- Exhibit
4(k)(2).)
*4(d)(3) -- First Supplemental Loan Agreement, dated as of March 31, 1992,
between the Pima County Authority and TEP relating to Industrial
Development Revenue Bonds, 1982 Series A (Tucson Electric Power
Company Projects). (Form S-4, Registration No. 33-52860 --
Exhibit 4(i)(3).)
*4(d)(4) -- First Supplemental Indenture of Trust, dated as of March 31,
1992, between the Pima County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1982 Series A
K-158
(Tucson Electric Power Company Projects). (Form S-4, Registration
No. 33-52860 -- Exhibit 4(i)(4).)
*4(e)(1) -- Loan Agreement, dated as of December 1, 1983, between the Apache
County Authority and TEP relating to Floating Rate Monthly Demand
Industrial Development Revenue Bonds, 1983 Series A (Tucson
Electric Power Company Springerville Project). (Form 10-K for the
year ended December 31, 1983, File No. 1-5924 -- Exhibit
4(I)(1).)
*4(e)(2) -- Indenture of Trust, dated as of December 1, 1983, between the
Apache County Authority and Morgan Guaranty authorizing Floating
Rate Monthly Demand Industrial Development Revenue Bonds, 1983
Series A (Tucson Electric Power Company Springerville Project).
(Form 10-K for the year ended December 31, 1983, File no. 1-5924
-- Exhibit 4(I)(2).)
*4(e)(3) -- First Supplemental Loan Agreement, dated as of December 1, 1985,
between the Apache County Authority and TEP relating to Floating
Rate Monthly Demand Industrial Development Revenue Bonds, 1983
Series A (Tucson Electric Power Company Springerville Project).
(Form 10-K for the year ended December 31, 1987, File No. 1-5924
-- Exhibit 4(k)(3).)
*4(e)(4) -- First Supplemental Indenture, dated as of December 1, 1985,
between the Apache County Authority and Morgan Guaranty relating
to Floating Rate Monthly Demand Industrial Development Revenue
Bonds, 1983 Series A (Tucson Electric Power Company Springerville
Project). (Form 10-K for the year ended December 31, 1987, File
No. 1-5924 -- Exhibit 4(k)(4).)
*4(e)(5) -- Second Supplemental Loan Agreement, dated as of March 31, 1992,
between the Apache County Authority and TEP relating to
Industrial Development Revenue Bonds, 1983 Series A (Tucson
Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(k)(5).)
*4(e)(6) -- Second Supplemental Indenture of Trust, dated as of March 31,
1992, between the Apache County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1983 Series A
(Tucson Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(k)(6).)
*4(f)(1) -- Loan Agreement, dated as of December 1, 1983, between the Apache
County Authority and TEP relating to Variable Rate Demand
Industrial Development Revenue Bonds, 1983 Series B (Tucson
Electric Power Company Springerville Project). (Form 10-K for the
year ended December 31, 1983, File No. 1-5924 -- Exhibit
4(m)(1).)
*4(f)(2) -- Indenture of Trust dated as of December 1, 1983, between the
Apache County Authority and Morgan Guaranty authorizing Variable
Rate Demand Industrial Development Revenue Bonds. 1983 Series B
(Tucson Electric Power Company Springerville Project). (Form 10-K
for the year ended December 31, 1983, File No. 1-5924 -- Exhibit
4(m)(2).)
*4(f)(3) -- First Supplemental Loan Agreement, dated as of December 1, 1985,
between the Apache County Authority and TEP relating to Floating
Rate Monthly Demand Industrial Developmental Revenue Bonds, 1983
Series B (Tucson Electric Power Company Springerville Project).
(Form 10-K for the year ended December 31, 1987, File No. 1-5924
-- Exhibit 4(I)(3).)
*4(f)(4) -- First Supplemental Indenture, dated as of December 1, 1985,
between the Apache County Authority and Morgan Guaranty relating
to Floating Rate Monthly Demand Industrial Development Revenue
Bonds, 1983 Series B (Tucson Electric Power Company Springerville
Project). (Form 10-K for the year ended December 31, 1987, File
No. 1-5924 -- Exhibit 4(I)(4).)
*4(f)(5) -- Second Supplemental Loan Agreement, dated as of March 31, 1992,
between the Apache County Authority and TEP relating to
Industrial Development Revenue Bonds, 1983 Series B (Tucson
Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(I)(5).)
K-159
*4(f)(6) -- Second Supplemental Indenture of Trust, dated as of March 31,
1992, between the Apache County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1983 Series B
(Tucson Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(I)(6).)
*4(g)(1) -- Loan Agreement, dated as of December 1, 1983, between the Apache
County Authority and TEP relating to Variable Rate Demand
Industrial Development Revenue Bonds, 1983 Series C (Tucson
Electric Power Company Springerville Project). (Form 10-K for
year ended December 31, 1983, File No. 1-5924 -- Exhibit
4(n)(1).)
*4(g)(2) -- Indenture of Trust dated as of December 1, 1983, between the
Apache County Authority and Morgan Guaranty authorizing Variable
Rate Demand Industrial Development Revenue Bonds, 1983 Series C
(Tucson Electric Power Company Springerville Project). (Form 10-K
for the year ended December 31, 1983, File No. 1-5924 -- Exhibit
4(n)(2).)
*4(g)(3) -- First Supplemental Loan Agreement, dated as of December 1, 1985,
between the Apache County Authority and TEP relating to Floating
Rate Monthly Demand Industrial Development Revenue Bonds, 1983
Series C (Tucson Electric Power Company Springerville Project).
(Form 10-K for the year ended December 31, 1987, File No. 1-5924
-- Exhibit 4(m)(3).)
*4(g)(4) -- First Supplemental Indenture, dated as of December 1, 1985,
between the Apache County Authority and Morgan Guaranty relating
to Floating Rate Monthly Demand Industrial Development Revenue
Bonds, 1983 Series C (Tucson Electric Power Company Springerville
Project). (Form 10-K for the year ended December 31, 1987, File
No. 1-5924 -- Exhibit 4(m)(4).)
*4(g)(5) -- Second Supplemental Loan Agreement, dated as of March 31, 1992,
between the Apache County Authority and TEP relating to
Industrial Development Revenue Bonds, 1983 Series C (Tucson
Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(m)(5).)
*4(g)(6) -- Second Supplemental Indenture of Trust, dated as of March 31,
1992, between the Apache County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1983 Series C
(Tucson Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(m)(6).)
*4(h) -- Reimbursement Agreement, dated as of September 15, 1981, as
amended, between TEP and Manufacturers Hanover Trust Company.
(Form 10-K for the year ended December 31, 1984, File No. 1-5924
-- Exhibit 4(o)(4).)
*4(i)(1) -- Loan Agreement, dated as of December 1, 1985, between the Apache
County Authority and TEP relating to Variable Rate Demand
Industrial Development Revenue Bonds, 1985 Series A (Tucson
Electric Power Company Springerville Project). (Form 10-K for the
year ended December 31, 1985, File No. 1-5924 -- Exhibit
4(r)(1).)
*4(i)(2) -- Indenture of Trust dated as of December 1, 1985, between the
Apache County Authority and Morgan Guaranty authorizing Variable
Rate Demand Industrial Development Revenue Bonds, 1985 Series A
(Tucson Electric Power Company Springerville Project). (Form 10-K
for the year ended December 31, 1985, File No. 1-5924 -- Exhibit
4(r)(2).)
*4(i)(3) -- First Supplemental Loan Agreement, dated as of March 31, 1992,
between the Apache County Authority and TEP relating to
Industrial Development Revenue Bonds, 1985 Series A (Tucson
Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(o)(3).)
*4(i)(4) -- First Supplemental Indenture of Trust, dated as of March 31,
1992, between the Apache County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1985 Series A
(Tucson Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(o)(4).)
K-160
*4(j)(1) -- Indenture of Mortgage and Deed of Trust dated as of December 1,
1992, to Bank of Montreal Trust Company, Trustee. (Form S-1,
Registration No. 33-55732 -- Exhibit 4(r)(1).)
*4(j)(2) -- Supplemental Indenture No. 1 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series A, dated as
of December 1, 1992. (Form S-1, Registration No. 33-55732 --
Exhibit 4(r)(2).)
*4(j)(3) -- Supplemental Indenture No. 2 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series B, dated as
of December 1, 1997. (Form 10-K for year ended December 31, 1997,
File No. 1-5924 -- Exhibit 4(m)(3).)
*4(j)(4) -- Supplemental Indenture No. 3 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series, dated as of
August 1, 1998. (Form 10-Q for the quarter ended June 30, 1998,
File No. 1-5924 -- Exhibit 4(c).)
*4(j)(5) -- Supplemental Indenture No. 4 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series C, dated as
of November 1, 2002. (Form 8-K dated November 27, 2002, File Nos.
1-05924 and 1-13739 -- Exhibit 99.2.)
*4(j)(6) -- Supplemental Indenture No. 5 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series D, dated as
of March 1, 2004. (Form 8-K dated March 31, 2004, File Nos.
1-05924 and 1-13739 -- Exhibit 10(b).)
*4(k)(1) -- Loan Agreement, dated as of April 1, 1997 between Coconino
County, Arizona Pollution Control Corporation and TEP relating to
Pollution Control Revenue Bonds, 1997 Series A (Tucson Electric
Power Company Navajo Project). (Form 10-Q for the quarter ended
March 31, 1997, File No. 1-5924 -- Exhibit 4(c).)
*4(k)(2) -- Indenture of Trust, dated as of April 1, 1997, between Coconino
County, Arizona Pollution Control Corporation and First Trust of
New York, National Association, authorizing Pollution Control
Revenue Bonds, 1997 Series A (Tucson Electric Power Company
Navajo Project). (Form 10-Q for the quarter ended March 31, 1997,
File No. 1-5924 -- Exhibit 4(d).)
*4(l)(1) -- Loan Agreement, dated as of April 1, 1997, between Coconino
County, Arizona Pollution Control Corporation and TEP relating to
Pollution Control Revenue Bonds, 1997 Series B (Tucson Electric
Power Company Navajo Project). (Form 10-Q for the quarter ended
March 31, 1997, File No. 1-5924 -- Exhibit 4(e).)
*4(l)(2) -- Indenture of Trust, dated as of April 1, 1997, between Coconino
County, Arizona Pollution Control Corporation and First Trust of
New York, National Association, authorizing Pollution Control
Revenue Bonds, 1997 Series B (Tucson Electric Power Company
Navajo Project). (Form 10-Q for the quarter ended March 31, 1997,
File No. 1-5924 -- Exhibit 4(f).)
*4(m)(1) -- Loan Agreement, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and TEP
relating to Industrial Development Revenue Bonds, 1997 Series A
(Tucson Electric Power Company Project). (Form 10-Q for the
quarter ended September 30, 1997, File No. 1-5924 -- Exhibit
4(a).)
*4(m)(2) -- Indenture of Trust, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and First
Trust of New York, National Association, authorizing Industrial
Development Revenue Bonds, 1997 Series A (Tucson Electric Power
Company Project). (Form 10-Q for the quarter ended September 30,
1997, File No. 1-5924 -- Exhibit 4(b).)
*4(n)(1) -- Loan Agreement, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and TEP
relating to Industrial Development Revenue Bonds, 1997 Series B
(Tucson Electric Power Company Project). (Form 10-Q for the
quarter ended September 30, 1997, File No. 1-5924 -- Exhibit
4(c).)
*4(n)(2) -- Indenture of Trust, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and First
Trust of New York, National Association, authorizing Industrial
K-161
Development Revenue Bonds, 1997 Series B (Tucson Electric Power
Company Project). (Form 10-Q for the quarter ended September 30,
1997, File No. 1-5924 -- Exhibit 4(d).)
*4(o)(1) -- Loan Agreement, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and TEP
relating to Industrial Development Revenue Bonds, 1997 Series C
(Tucson Electric Power Company Project). (Form 10-Q for the
quarter ended September 30, 1997, File No. 1-5924 -- Exhibit
4(e).)
*4(o)(2) -- Indenture of Trust, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and First
Trust of New York, National Association, authorizing Industrial
Development Revenue Bonds, 1997 Series C (Tucson Electric Power
Company Project). (Form 10-Q for the quarter ended September 30,
1997, File No. 1-5924 -- Exhibit 4(f).)
*4(p)(1) -- Loan Agreement, dated as of March 1, 1998, between The Industrial
Development Authority of the County of Apache and TEP relating
to Pollution Control Revenue Bonds, 1998 Series A (Tucson
Electric Power Company Project). (Form 10-Q for the quarter ended
March 31, 1998, File No. 1-5924 -- Exhibit 4(a).)
*4(p)(2) -- Indenture of Trust, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and
First Trust of New York, National Association, authorizing
Pollution Control Revenue Bonds, 1998 Series A (Tucson Electric
Power Company Project). (Form 10-Q for the quarter ended March
31, 1998, File No. 1-5924 -- Exhibit 4(b).)
*4(q)(1) -- Loan Agreement, dated as of March 1, 1998, between The Industrial
Development Authority of the County of Apache and TEP relating to
Pollution Control Revenue Bonds, 1998 Series B (Tucson Electric
Power Company Project). (Form 10-Q for the quarter ended March
31, 1998, File No. 1-5924 -- Exhibit 4(c).)
*4(q)(2) -- Indenture of Trust, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and
First Trust of New York, National Association, authorizing
Pollution Control Revenue Bonds, 1998 Series B (Tucson Electric
Power Company Project). (Form 10-Q for the quarter ended March
31, 1998, File No. 1-5924 -- Exhibit 4(d).)
*4(r)(1) -- Loan Agreement, dated as of March 1, 1998, between The Industrial
Development Authority of the County of Apache and TEP relating to
Industrial Development Revenue Bonds, 1998 Series C (Tucson
Electric Power Company Project). (Form 10-Q for the quarter ended
March 31, 1998, File No. 1-5924 -- Exhibit 4(e).)
*4(r)(2) -- Indenture of Trust, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and
First Trust of New York, National Association, authorizing
Industrial Development Revenue Bonds, 1998 Series C (Tucson
Electric Power Company Project). (Form 10-Q for the quarter ended
March 31, 1998, File No. 1-5924 -- Exhibit 4(f).)
*4(s)(1) -- Indenture of Trust, dated as of August 1, 1998, between TEP and
the Bank of Montreal Trust Company. (Form 10-Q for the quarter
ended June 30, 1998, File No. 1-5924 -- Exhibit 4(d).)
*4(t)(1) -- Rights Agreement dated as of March 5, 1999, between UniSource
Energy Corporation and The Bank of New York, as Rights Agent.
(Form 8-K dated March 5, 1999, File No. 1-13739 -- Exhibit 4.)
*4(u)(1) -- Credit Agreement dated as of March 25, 2004, among TEP, JP Morgan
Chase Bank, Credit Suisse First Boston and Lehman Brothers, Inc.,
as Co-Administrative Agents, The Bank of New York and Union Bank
of California, N.A., as Documentation Agents, and Credit Suisse
First Boston, as Paying Agent, the Lenders party Thereto, and the
Issuing Banks Party Thereto. (Form 8-K dated March 31, 2004, File
Nos. 1-5924 and 1-13739 -- Exhibit 10(a).)
K-162
*4(v)(1) -- Note Purchase and Guaranty Agreement dated August 11, 2003 among
UNS Gas, Inc., and UniSource Energy Services, Inc., and certain
institutional investors. (Form 8-K dated August 21, 2003, File
Nos. 1-5924 and 1-13739 -- Exhibit 99.2.)
*4(w)(1) -- Note Purchase and Guaranty Agreement date August 11, 2003 among
UNS Electric, Inc., and UniSource Energy Services, Inc., and
certain institutional investors. (Form 8-K dated August 21, 2003,
File Nos. 1-5924 and 1-13739 -- Exhibit 99.3.)
*4(x)(1) -- Indenture dated as of March 1, 2005, to The Bank of New York, as
Trustee. (Form 8-K dated March 3, 2005, File Nos. 1-5924 and
1-13739 -- Exhibit 4.1).
*4(y)(1) -- Registration Rights Agreement, dated as of March 1, 2005, between
UniSource Energy Corporation and Credit Suisse First Boston LLC,
as representative of the several initial purchasers (Form 8-K
dated March 3, 2005, File Nos. 1-5924 and 1-13739 -- Exhibit
4.2).
*10(a)(1) -- Lease Agreements, dated as of December 1, 1984, between Valencia
and United States Trust Company of New York, as Trustee, and
Thomas B. Zakrzewski, as Co-Trustee, as amended and supplemented.
(Form 10-K for the year ended December 31, 1984, File No. 1-5924
-- Exhibit 10(d)(1).)
*10(a)(2) -- Guaranty and Agreements, dated as of December 1, 1984, between
TEP and United States Trust Company of New York, as Trustee, and
Thomas B. Zakrzewski, as Co-Trustee. (Form 10-K for the year
ended December 31, 1984, File No. 1-5924 -- Exhibit 10(d)(2).)
*10(a)(3) -- General Indemnity Agreements, dated as of December 1, 1984,
between Valencia and TEP, as Indemnitors; General Foods Credit
Corporation, Harvey Hubbell Financial, Inc. and J.C. Penney
Company, Inc. as Owner Participants; United States Trust Company
of New York, as Owner Trustee; Teachers Insurance and Annuity
Association of America as Loan Participant; and Marine Midland
Bank, N.A., as Indenture Trustee. (Form 10-K for the year ended
December 31, 1984, File No. 1-5924 -- Exhibit 10(d)(3).)
*10(a)(4) -- Tax Indemnity Agreements, dated as of December 1, 1984, between
General Foods Credit Corporation, Harvey Hubbell Financial, Inc.
and J.C. Penney Company, Inc., each as Beneficiary under a
separate Trust Agreement dated December 1, 1984, with United
States Trust of New York as Owner Trustee, and Thomas B.
Zakrzewski as Co-Trustee, Lessor, and Valencia, Lessee, and TEP,
Indemnitors. (Form 10-K for the year ended December 31, 1984,
File No. 1-5924 -- Exhibit 10(d)(4).)
*10(a)(5) -- Amendment No. 1, dated December 31, 1984, to the Lease
Agreements, dated December 1, 1984, between Valencia and United
States Trust Company of New York, as Owner Trustee, and Thomas B.
Zakrzewski as Co-Trustee. (Form 10-K for the year ended December
31, 1986, File No. 1-5924 -- Exhibit 10(e)(5).)
*10(a)(6) -- Amendment No. 2, dated April 1, 1985, to the Lease Agreements,
dated December 1, 1984, between Valencia and United States Trust
Company of New York, as Owner Trustee, and Thomas B. Zakrzewski
as Co-Trustee. (Form 10-K for the year ended December 31, 1986,
File No. 1-5924 -- Exhibit 10(e)(6).)
*10(a)(7) -- Amendment No. 3 dated August 1, 1985, to the Lease Agreements,
dated December 1, 1984, between Valencia and United States Trust
Company of New York, as Owner Trustee, and Thomas Zakrzewski as
Co-Trustee. (Form 10-K for the year ended December 31, 1986, File
No. 1-5924 -- Exhibit 10(e)(7).)
*10(a)(8) -- Amendment No. 4, dated June 1, 1986, to the Lease Agreement,
dated December 1, 1984, between Valencia and United States Trust
Company of New York as Owner Trustee, and Thomas Zakrzewski as
Co-Trustee, under a Trust Agreement dated as of December 1, 1984,
with General Foods Credit Corporation as Owner Participant. (Form
10-K for the year ended December 31, 1986, File No. 1-5924 --
Exhibit 10(e)(8).)
*10(a)(9) -- Amendment No. 4, dated June 1, 1986, to the Lease Agreement,
dated December 1, 1984, between Valencia and United States Trust
Company of New York as Owner Trustee, and Thomas Zakrzewski as
K-163
Co-Trustee, under a Trust Agreement dated as of December 1, 1984,
with J.C. Penney Company, Inc. as Owner Participant. (Form 10-K
for the year ended December 31, 1986, File No. 1-5924 -- Exhibit
10(e)(9).)
*10(a)(10) -- Amendment No. 4, dated June 1, 1986, to the Lease Agreement,
dated December 1, 1984, between Valencia and United States Trust
Company of New York as Owner Trustee, and Thomas Zakrzewski as
Co-Trustee, under a Trust Agreement dated as of December 1, 1984,
with Harvey Hubbell Financial Inc. as Owner Participant. (Form
10-K for the year ended December 31, 1986, File No. 1-5924 --
Exhibit 10(e)(10).)
*10(a)(11) -- Lease Amendment No. 5 and Supplement No. 2, to the Lease
Agreement, dated July 1, 1986, between Valencia, United States
Trust Company of New York as Owner Trustee, and Thomas Zakrzewski
as Co-Trustee and J.C. Penney as Owner Participant. (Form 10-K
for the year ended December 31, 1986, File No. 1-5924 -- Exhibit
10(e)(11).)
*10(a)(12) -- Lease Amendment No. 5, to the Lease Agreement, dated June 1,
1987, between Valencia, United States Trust Company of New York
as Owner Trustee, and Thomas Zakrzewski as Co-Trustee and General
Foods Credit Corporation as Owner Participant. (Form 10-K for the
year ended December 31, 1988, File No. 1-5924 -- Exhibit
10(f)(12).)
*10(a)(13) -- Lease Amendment No. 5, to the Lease Agreement, dated June 1,
1987, between Valencia, United States Trust Company of New York
as Owner Trustee, and Thomas Zakrzewski as Co-Trustee and Harvey
Hubbell Financial Inc. as Owner Participant. (Form 10-K for the
year ended December 31, 1988, File No. 1-5924 -- Exhibit
10(f)(13).)
*10(a)(14) -- Lease Amendment No. 6, to the Lease Agreement, dated June 1,
1987, between Valencia, United States Trust Company of New York
as Owner Trustee, and Thomas Zakrzewski as Co-Trustee and J.C.
Penney Company, Inc. as Owner Participant. (Form 10-K for the
year ended December 31, 1988, File No. 1-5924 -- Exhibit
10(f)(14).)
*10(a)(15) -- Lease Supplement No. 1, dated December 31, 1984, to Lease
Agreements, dated December 1, 1984, between Valencia, as Lessee
and United States Trust Company of New York and Thomas B.
Zakrzewski, as Owner Trustee and Co-Trustee, respectively
(document filed relates to General Foods Credit Corporation;
documents relating to Harvey Hubbell Financial, Inc. and JC
Penney Company, Inc. are not filed but are substantially
similar). (Form S-4 Registration No. 33-52860 -- Exhibit
10(f)(15).)
*10(a)(16) -- Amendment No. 1, dated June 1, 1986, to the General Indemnity
Agreement, dated as of December 1, 1984, between Valencia and
TEP, as Indemnitors, General Foods Credit Corporation, as Owner
Participant, United States Trust Company of New York, as Owner
Trustee, Teachers Insurance and Annuity Association of America,
as Loan Participant, and Marine Midland Bank, N.A., as Indenture
Trustee. (Form 10-K for the year ended December 31, 1986, File
No. 1-5924 -- Exhibit 10(e)(12).)
*10(a)(17) -- Amendment No. 1, dated June 1, 1986, to the General Indemnity
Agreement, dated as of December 1, 1984, between Valencia and
TEP, as Indemnitors, J.C. Penney Company, Inc., as Owner
Participant, United States Trust Company of New York, as Owner
Trustee, Teachers Insurance and Annuity Association of America,
as Loan Participant, and Marine Midland Bank, N.A., as Indenture
Trustee. (Form 10-K for the year ended December 31, 1986, File
No. 1-5924 -- Exhibit 10(e)(13).)
*10(a)(18) -- Amendment No. 1, dated June 1, 1986, to the General Indemnity
Agreement, dated as of December 1, 1984, between Valencia and
TEP, as Indemnitors, Harvey Hubbell Financial, Inc., as Owner
Participant, United States Trust Company of New York, as Owner
Trustee, Teachers Insurance and Annuity Association of America,
as Loan Participant, and Marine Midland Bank, N.A., as Indenture
Trustee. (Form 10-K for the year ended December 31, 1986, File
No. 1-5924 -- Exhibit 10(e)(14).)
*10(a)(19) -- Amendment No. 2, dated as of July 1, 1986, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, J.C. Penney Company, Inc., as
K-164
Owner Participant, United States Trust Company of New York, as
Owner Trustee, Teachers Insurance and Annuity Association of
America, as Loan Participant, and Marine Midland Bank, N.A., as
Indenture Trustee. (Form S-4, Registration No. 33-52860 --
Exhibit 10(f)(19).)
*10(a)(20) -- Amendment No. 2, dated as of June 1, 1987, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, General Foods Credit
Corporation, as Owner Participant, United States Trust Company of
New York, as Owner Trustee, Teachers Insurance and Annuity
Association of America, as Loan Participant, and Marine Midland
Bank, N.A., as Indenture Trustee. (Form S-4, Registration No.
33-52860 --Exhibit 10(f)(20).)
*10(a)(21) -- Amendment No. 2, dated as of June 1, 1987, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, Harvey Hubbell Financial, Inc.,
as Owner Participant, United States Trust Company of New York, as
Owner Trustee, Teachers Insurance and Annuity Association of
America, as Loan Participant, and Marine Midland Bank, N.A., as
Indenture Trustee. (Form S-4, Registration No. 33-52860 --
Exhibit 10(f)(21).)
*10(a)(22) -- Amendment No. 3, dated as of June 1, 1987, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, J.C. Penney Company, Inc., as
Owner Participant, United States Trust Company of New York, as
Owner Trustee, Teachers Insurance and Annuity Association of
America, as Loan Participant, and Marine Midland Bank, N.A., as
Indenture Trustee. (Form S-4, Registration No. 33-52860 --
Exhibit 10(f)(22).)
*10(a)(23) -- Supplemental Tax Indemnity Agreement, dated July 1, 1986, between
J.C. Penney Company, Inc., as Owner Participant, and Valencia and
TEP, as Indemnitors. (Form 10-K for the year ended December 31,
1986, File No. 1-5924 -- Exhibit 10(e)(15).)
*10(a)(24) -- Supplemental General Indemnity Agreement, dated as of July 1,
1986, among Valencia and TEP, as Indemnitors, J.C. Penney
Company, Inc., as Owner Participant, United States Trust Company
of New York, as Owner Trustee, Teachers Insurance and Annuity
Association of America, as Loan Participant, and Marine Midland
Bank, N.A., as Indenture Trustee. (Form 10-K for the year ended
December 31, 1986, File No. 1-5924 -- Exhibit 10(e)(16).)
*10(a)(25) -- Amendment No. 1, dated as of June 1, 1987, to the Supplemental
General Indemnity Agreement, dated as of July 1, 1986, among
Valencia and TEP, as Indemnitors, J.C. Penney Company, Inc., as
Owner Participant, United States Trust Company of New York, as
Owner Trustee, Teachers Insurance and Annuity Association of
America, as Loan Participant, and Marine Midland Bank, N.A., as
Indenture Trustee. (Form S-4, Registration No. 33-52860 --
Exhibit 10(f)(25).)
*10(a)(26) -- Valencia Agreement, dated as of June 30, 1992, among TEP, as
Guarantor, Valencia, as Lessee, Teachers Insurance and Annuity
Association of America, as Loan Participant, Marine Midland Bank,
N.A., as Indenture Trustee, United States Trust Company of New
York, as Owner Trustee, and Thomas B. Zakrzewski, as Co-Trustee,
and the Owner Participants named therein relating to the
Restructuring of Valencia's lease of the coal-handling facilities
at the Springerville Generating Station. (Form S-4, Registration
No. 33-52860 -- Exhibit 10(f)(26).)
*10(a)(27) -- Amendment, dated as of December 15, 1992, to the Lease
Agreements, dated December 1, 1984, between Valencia, as Lessee,
and United States Trust Company of New York, as Owner Trustee,
and Thomas B. Zakrzewski, as Co-Trustee. (Form S-1, Registration
No. 33-55732 -- Exhibit 10(f)(27).)
*10(b)(1) -- Lease Agreements, dated as of December 1, 1985, between TEP and
San Carlos Resources Inc. (San Carlos) (a wholly-owned subsidiary
of the Registrant) jointly and severally, as Lessee, and
Wilmington Trust Company, as Trustee, as amended and
supplemented. (Form 10-K for the year ended December 31, 1985,
File No. 1-5924 -- Exhibit 10(f)(1).)
K-165
*10(b)(2) -- Tax Indemnity Agreements, dated as of December 1, 1985, between
Philip Morris Credit Corporation, IBM Credit Financing
Corporation and Emerson Finance Co., each as beneficiary under a
separate trust agreement, dated as of December 1, 1985, with
Wilmington Trust Company, as Owner Trustee, and William J. Wade,
as Co-Trustee, and TEP and San Carlos, as Lessee. (Form 10-K for
the year ended December 31, 1985, File No. 1-5924 -- Exhibit
10(f)(2).)
*10(b)(3) -- Participation Agreement, dated as of December 1, 1985, among TEP
and San Carlos as Lessee, Philip Morris Credit Corporation, IBM
Credit Financing Corporation, and Emerson Finance Co. as Owner
Participants, Wilmington Trust Company as Owner Trustee, The
Sumitomo Bank, Limited, New York Branch, as Loan Participant, and
Bankers Trust Company, as Indenture Trustee. (Form 10-K for the
year ended December 31, 1985, File No. 1-5924 -- Exhibit
10(f)(3).)
*10(b)(4) -- Restructuring Commitment Agreement, dated as of June 30, 1992,
among TEP and San Carlos, jointly and severally, as Lessee,
Philip Morris Credit Corporation, IBM Credit Financing
Corporation and Emerson Capital Funding, William J. Wade, as
Owner Trustee and Co-Trustee, respectively, The Sumitomo Bank,
Limited, New York Branch, as Loan Participant and United States
Trust Company of New York, as Indenture Trustee. (Form S-4,
Registration No. 33-52860 -- Exhibit 10(g)(4).)
*10(b)(5) -- Lease Supplement No.1, dated December 31, 1985, to Lease
Agreements, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee Trustee and Co-Trustee,
respectively (document filed relates to Philip Morris Credit
Corporation; documents relating to IBM Credit Financing
Corporation and Emerson Financing Co. are not filed but are
substantially similar). (Form S-4, Registration No. 33-52860 --
Exhibit 10(g)(5).)
*10(b)(6) -- Amendment No. 1, dated as of December 15, 1992, to Lease
Agreements, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, as Lessor. (Form S-1, Registration No. 33-55732 --
Exhibit 10(g)(6).)
*10(b)(7) -- Amendment No. 1, dated as of December 15, 1992, to Tax Indemnity
Agreements, dated as of December 1, 1985, between Philip Morris
Credit Corporation, IBM Credit Financing Corporation and Emerson
Capital Funding Corp., as Owner Participants and TEP and San
Carlos, jointly and severally, as Lessee. (Form S-1, Registration
No. 33-55732 -- Exhibit 10(g)(7).)
*10(b)(8) -- Amendment No. 2, dated as of December 1, 1999, to Lease
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, under a Trust Agreement with Philip Morris Capital
Corporation as Owner Participant. (Form 10-K for the year ended
December 31, 1999, File No. 1-5924 -- Exhibit 10(b)(8).)
*10(b)(9) -- Amendment No. 2, dated as of December 1, 1999, to Lease
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, under a Trust Agreement with IBM Credit Financing
Corporation as Owner Participant. (Form 10-K for the year ended
December 31, 1999, File No. 1-5924 -- Exhibit 10(b)(9).)
*10(b)(10) -- Amendment No. 2, dated as of December 1, 1999, to Lease
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, under a Trust Agreement with Emerson Finance Co. as
Owner Participant. (Form 10-K for the year ended December 31,
1999, File No. 1-5924 -- Exhibit 10(b)(10).)
*10(b)(11) -- Amendment No. 2, dated as of December 1, 1999, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Philip Morris
Capital Corporation as Owner Participant, beneficiary under a
Trust Agreement dated as of December 1, 1985, with Wilmington
K-166
Trust Company and William J. Wade, as Owner Trustee and
Co-Trustee, respectively, together as Lessor. (Form 10-K for the
year ended December 31, 1999, File No. 1-5924 -- Exhibit
10(b)(11).)
*10(b)(12) -- Amendment No. 2, dated as of December 1, 1999, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and IBM Credit
Financing Corporation as Owner Participant, beneficiary under a
Trust Agreement dated as of December 1, 1985, with Wilmington
Trust Company and William J. Wade, as Owner Trustee and
Co-Trustee, respectively, together as Lessor. (Form 10-K for the
year ended December 31, 1999, File No. 1-5924 -- Exhibit
10(b)(12).)
*10(b)(13) -- Amendment No. 2, dated as of December 1, 1999, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Emerson Finance Co.
as Owner Participant, beneficiary under a Trust Agreement dated
as of December 1, 1985, with Wilmington Trust Company and William
J. Wade, as Owner Trustee and Co-Trustee, respectively, together
as Lessor. (Form 10-K for the year ended December 31, 1999, File
No. 1-5924 -- Exhibit 10(b)(13).)
*10(b)(14) -- Amendment No. 3 dated as of June 1, 2003, to Lease Agreements,
dated as of December 1, 1985, between TEP and San Carlos, jointly
and severally, as Lessee, and Wilmington Trust Company and
William J. Wade, as Owner Trustee and Co-Trustee, respectively,
under a Trust Agreement with Philip Morris Capital Corporation as
Owner Participant.
*10(b)(15) -- Amendment No. 3 dated as of June 1, 2003, to Lease Agreements,
dated as of December 1, 1985, between TEP and San Carlos, jointly
and severally, as Lessee, and Wilmington Trust Company and
William J. Wade, as Owner Trustee and Co-Trustee, respectively,
under a Trust Agreement with IBM Credit, LLC as Owner
Participant.
*10(b)(16) -- Amendment No. 3 dated as of June 1, 2003, to Lease Agreements,
dated as of December 1, 1985, between TEP and San Carlos, jointly
and severally, as Lessee, and Wilmington Trust Company and
William J. Wade, as Owner Trustee and Co-Trustee, respectively,
under a Trust Agreement with Emerson Finance Co. as Owner
Participant.
*10(b)(17) -- Amendment No. 3 dated as of June 1, 2003, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Philip Morris
Capital Corporation as Owner Participant, beneficiary under a
Trust Agreement dated as of December 1, 1985, with Wilmington
Trust Company and William J. Wade, as Owner Trustee and
Co-Trustee, respectively, together as Lessor.
*10(b)(18) -- Amendment No. 3 dated as of June 1, 2003, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and IBM Credit, LLC as
Owner Participant, beneficiary under a Trust Agreement dated as
of December 1, 1985, with Wilmington Trust Company and William J.
Wade, as Owner Trustee and Co-Trustee, respectively, together as
Lessor.
*10(b)(19) -- Amendment No. 3 dated as of June 1, 2003, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Emerson Finance Co.
as Owner Participant, beneficiary under a Trust Agreement dated
as of December 1, 1985, with Wilmington Trust Company and William
J. Wade, as Owner Trustee and Co-Trustee, respectively, together
as Lessor.
*10(c)(1) -- Amended and Restated Participation Agreement, dated as of
November 15, 1987, among TEP, as Lessee, Ford Motor Credit
Company, as Owner Participant, Financial Security Assurance Inc.,
as Surety, Wilmington Trust Company and William J. Wade in their
respective individual capacities as provided therein, but
otherwise solely as Owner Trustee and Co-Trustee under the Trust
Agreement, and Morgan Guaranty, in its individual capacity as
provided therein, but Secured Party. (Form 10-K for the year
ended December 31, 1987, File No. 1-5924 -- Exhibit 10(j)(1).)
*10(c)(2) -- Lease Agreement, dated as of January 14, 1988, between Wilmington
Trust Company and William J. Wade, as Owner Trust Agreement
described therein, dated as of November 15, 1987, between such
K-167
parties and Ford Motor Credit Company, as Lessor, and TEP, as
Lessee. (Form 10-K for the year ended December 31, 1987, File
No.1-5924 -- Exhibit 10(j)(2).)
*10(c)(3) -- Tax Indemnity Agreement, dated as of January 14, 1988, between
TEP, as Lessee, and Ford Motor Credit Company, as Owner
Participant, beneficiary under a Trust Agreement, dated as of
November 15, 1987, with Wilmington Trust Company and William J.
Wade, Owner Trustee and Co-Trustee, respectively, together as
Lessor. (Form 10-K for the year ended December 31, 1987, File No.
1-5924 -- Exhibit 10(j)(3).)
*10(c)(4) -- Loan Agreement, dated as of January 14, 1988, between the Pima
County Authority and Wilmington Trust Company and William J. Wade
in their respective individual capacities as expressly stated,
but otherwise solely as Owner Trustee and Co-Trustee,
respectively, under and pursuant to a Trust Agreement, dated as
of November 15, 1987, with Ford Motor Credit Company as Trustor
and Debtor relating to Industrial Development Lease Obligation
Refunding Revenue Bonds, 1988 Series A (TEP's Sundt Project).
(Form 10-K for the year ended December 31, 1987, File No. 1-5924
-- Exhibit 10(j)(4).)
*10(c)(5) -- Indenture of Trust, dated as of January 14, 1988, between the
Pima County Authority and Morgan Guaranty authorizing Industrial
Development Lease Obligation Refunding Revenue Bonds, 1988 Series
A (Tucson Electric Power Company Sundt Project). (Form 10-K for
the year ended December 31, 1987, File No. 1-5924 -- Exhibit
10(j)(5).)
*10(c)(6) -- Lease Amendment No. 1, dated as of May 1, 1989, between TEP,
Wilmington Trust Company and William J. Wade as Owner Trustee and
Co-Trustee, respectively under a Trust Agreement dated as of
November 15, 1987 with Ford Motor Credit Company. (Form 10-K for
the year ended December 31, 1990, File No. 1-5924 -- Exhibit
10(i)(6).)
*10(c)(7) -- Lease Supplement, dated as of January 1, 1991, between TEP,
Wilmington Trust Company and William J. Wade as Owner Trustee and
Co-Trustee, respectively, under a Trust Agreement dated as of
November 15, 1987, with Ford. (Form 10-K for the year ended
December 31, 1991, File No. 1-5924 -- Exhibit 10(i)(8).)
*10(c)(8) -- Lease Supplement, dated as of March 1, 1991, between TEP,
Wilmington Trust Company and William J. Wade as Owner Trustee and
Co-Trustee, respectively, under a Trust Agreement dated as of
November 15, 1987, with Ford. (Form 10-K for the year ended
December 31, 1991, File No. 1-5924 -- Exhibit 10(i)(9).)
*10(c)(9) -- Lease Supplement No. 4, dated as of December 1, 1991, between
TEP, Wilmington Trust Company and William J. Wade as Owner
Trustee and Co-Trustee, respectively, under a Trust Agreement
dated as of November 15, 1987, with Ford. (Form 10-K for the year
ended December 31, 1991, File No. 1-5924 -- Exhibit 10(i)(10).)
*10(c)(10) -- Supplemental Indenture No. 1, dated as of December 1, 1991,
between the Pima County Authority and Morgan Guaranty relating to
Industrial Lease Development Obligation Revenue Project. (Form
10-K for the year ended December 31, 1991, File No. 1-5924 --
Exhibit 10(l)(11).)
*10(c)(11) -- Restructuring Commitment Agreement, dated as of June 30, 1992,
among TEP, as Lessee, Ford Motor Credit Company, as Owner
Participant, Wilmington Trust Company and William J. Wade, as
Owner Trustee and Co-Trustee, respectively, and Morgan Guaranty,
as Indenture Trustee and Refunding Trustee, relating to the
restructuring of the Registrant's lease of Unit 4 at the Sundt
Generating Station. (Form S-4, Registration No. 33-52860 --
Exhibit 10(i)(12).)
*10(c)(12) -- Amendment No. 1, dated as of December 15, 1992, to Amended and
Restated Participation Agreement, dated as of November 15, 1987,
among TEP, as Lessee, Ford Motor Credit Company, as Owner
Participant, Wilmington Trust Company and William J. Wade, as
Owner Trustee and Co-Trustee, respectively, Financial Security
Assurance Inc., as Surety, and Morgan Guaranty, as Indenture
Trustee. (Form S-1, Registration No. 33-55732 -- Exhibit
10(h)(12).)
K-168
*10(c)(13) -- Amended and Restated Lease, dated as of December 15, 1992,
between TEP as Lessee and Wilmington Trust Company and William J.
Wade, as Owner Trustee and Co-Trustee, respectively, as Lessor.
(Form S-1, Registration No. 33-55732 -- Exhibit 10(h)(13).)
*10(c)(14) -- Amended and Restated Tax Indemnity Agreement, dated as of
December 15, 1992, between TEP as Lessee and Ford Motor Credit
Company, as Owner Participant. (Form S-1, Registration No.
33-55732 -- Exhibit 10(h)(14).)
*10(d) -- Power Sale Agreement for the years 1990 to 2011, dated as of
March 10, 1988, between TEP and Salt River Project Agricultural
Improvement and Power District. (Form 10-K for the year ended
December 31, 1987, File No. 1-5924 -- Exhibit 10(k).)
*10(e) -- Participation Agreement, dated as of June 30, 1992, among TEP, as
Lessee, various parties thereto, as Owner, Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, and LaSalle National Bank, as Indenture Trustee
relating to TEP's lease of Springerville Unit 1. (Form S-1,
Registration No. 33-55732 -- Exhibit 10(u).)
*10(f) -- Lease Agreement, dated as of December 15, 1992, between TEP, as
Lessee and Wilmington Trust Company and William J. Wade, as Owner
Trustee and Co-Trustee, respectively, as Lessor. (Form S-1,
Registration No. 33-55732 -- Exhibit 10(v).)
*10(g) -- Tax Indemnity Agreements, dated as of December 15, 1992, between
the various Owner Participants parties thereto and TEP, as
Lessee. (Form S-1, Registration No. 33-55732 -- Exhibit 10(w).)
*10(h) -- Restructuring Agreement, dated as of December 1, 1992, between
TEP and Century Power Corporation. (Form S-1, Registration No.
33-55732 -- Exhibit 10(x).)
*10(i) -- Voting Agreement, dated as of December 15, 1992, between TEP and
Chrysler Capital Corporation (documents relating to CILCORP Lease
Management, Inc., MWR Capital Inc., US West Financial Services,
Inc. and Philip Morris Capital Corporation are not filed but are
substantially similar). (Form S-1, Registration No. 33-55732 --
Exhibit 10(y).)
*10(j)(1) -- Wholesale Power Supply Agreement between TEP and Navajo Tribal
Utility Authority dated January 5, 1993. (Form 10-K for the year
ended December 31, 1992, File No. 1-5924 -- Exhibit 10(t).)
*10(j)(2) -- Amended and Restated Wholesale Power Supply Agreement between TEP
and Navajo Tribal Utility Authority, dated June 25, 1997. (Form
10-Q for the quarter ended June 30, 1997, File No. 1-5924 --
Exhibit 10.)
+*10(k) -- 1994 Omnibus Stock and Incentive Plan of UniSource Energy. (Form
S-8 dated January 6, 1998, File No. 333-43767.)
+*10(l) -- Management and Directors Deferred Compensation Plan of UniSource
Energy. (Form S-8 dated January 6, 1998, File No. 333-43769.)
+*10(m) -- TEP Supplemental Retirement Account for Classified Employees.
(Form S-8 dated May 21, 1998, File No. 333-53309.)
+*10(n) -- TEP Triple Investment Plan for Salaried Employees. (Form S-8
dated May 21, 1998, File No. 333-53333.)
+*10(o) -- UniSource Energy Management and Directors Deferred Compensation
Plan. (Form S-8 dated May 21, 1998, File No. 333-53337.)
+10(p) -- Officer Change in Control Agreement between TEP and Karen G.
Kissinger, dated as of December 4, 1998 (including a schedule of
other officers who are covered by substantially identical
agreements.)
K-169
+10(q) -- Notice of Termination of Change in Control Agreement from TEP
to Karen G. Kissinger, dated as of March 3, 2005 (including a
schedule of other officers who received substantially identical
notices.)
+*10(r) -- Amended and Restated UniSource Energy 1994 Outside Director Stock
Option Plan of UniSource Energy. (Form S-8 dated September 9,
2002, File No. 333-99317.)
*10(s)(1) -- Asset Purchase Agreement dated as of October 29, 2002, by and
between UniSource Energy and Citizens Communications Company
relating to the Purchase of Citizens' Electric Utility Business
in the State of Arizona. (Form 8-K dated October 31, 2002. File
No. 1-13739 -- Exhibit 99-1.)
*10(s)(2) -- Asset Purchase Agreement dated as of October 29, 2002, by and
between UniSource Energy and Citizens Communications Company
relating to the Purchase of Citizens' Gas Utility Business in the
State of Arizona. (Form 8-K dated October 31, 2002. File No.
1-13739 -- Exhibit 99-2.)
12(a) -- Computation of Ratio of Earnings to Fixed Charges - TEP.
12(b) -- Computation of Ratio of Earnings to Fixed Charges - UniSource
Energy.
21 -- Subsidiaries of the Registrants.
23(a) -- Consent of Independent Registered Public Accounting Firm -
UniSource Energy
23(b) -- Consent of Independent Registered Public Accounting Firm - Tucson
Electric Power Company
24(a) -- Power of Attorney - UniSource Energy.
24(b) -- Power of Attorney - TEP.
31(a) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act -
UniSource Energy, by James S. Pignatelli.
31(b) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act -
UniSource Energy by Kevin P. Larson.
31(c) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act -
TEP, by James S. Pignatelli.
31(d) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act -
TEP, by Kevin P. Larson.
**32 -- Statements of Corporate Officers (pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002).
(*) Previously filed as indicated and incorporated herein by reference.
(+) Management contracts or compensatory plans or arrangements required to be
filed as exhibits to this Form 10-K by item 601(b)(10)(iii) of Regulation
S-K.
** Pursuant to Item 601(b)(32)(ii) of Regulation S-K, this certificate is not
being filed for purposes of Section 18 of the Securities Act of 1934.
K-170