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FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS
 9 Months Ended
Sep. 30, 2014
Disclosure Text Block [Abstract]  
FAIR VALUE MEASUREMENTS & DERIVATIVE INSTRUMENTS
FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS
We categorize our assets and liabilities accounted for at fair value into the three-level hierarchy based on inputs used to determine the fair value. Level 1 inputs are unadjusted quoted prices for identical assets or liabilities in an active market. Level 2 inputs include quoted prices for similar assets or liabilities, quoted prices in non-active markets, and pricing models whose inputs are observable, directly or indirectly. Level 3 inputs are unobservable and supported by little or no market activity. Transfers between levels are recorded at the end of a reporting period. There were no transfers between levels in the periods presented.
FINANCIAL INSTRUMENTS MEASURED AT FAIR VALUE ON A RECURRING BASIS
The following tables present, by level within the fair value hierarchy, TEP’s assets and liabilities accounted for at fair value on a recurring basis. These assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Counterparty Netting of Energy Contracts Not Offset on the Balance Sheets(5)
 
Net Amount
 
September 30, 2014
 
Millions of Dollars
Assets
 
 
 
Cash Equivalents(1)
$
10

 
$
10

 
$
—

 
$
—

 
$
—

 
$
10

Restricted Cash(1)
2

 
2

 
—

 
—

 
—

 
2

Rabbi Trust Investments(2)
25

 
—

 
25

 
—

 
—

 
25

Energy Contracts - Regulatory Recovery(3)
1

 
—

 
1

 
—

 
(1
)
 
—

Total Assets
38

 
12

 
26

 
—

 
(1
)
 
37

Liabilities
 
 
 
 
 
 
 
 
 
 
 
Energy Contracts - Regulatory Recovery(3)
(5
)
 
—

 
(2
)
 
(3
)
 
1

 
(4
)
Energy Contracts - Cash Flow Hedge(3)
(1
)
 
—

 
—

 
(1
)
 
—

 
(1
)
Interest Rate Swaps(4)
(4
)
 
—

 
(4
)
 
—

 
—

 
(4
)
Total Liabilities
(10
)
 
—

 
(6
)
 
(4
)
 
1

 
(9
)
Net Total Assets (Liabilities)
$
28

 
$
12

 
$
20

 
$
(4
)
 
$
—

 
$
28

 
Total
 
Level 1
 
Level 2
 
Level 3
 
Counterparty Netting of Energy Contracts Not Offset on the Balance Sheets(5)
 
Net Amount
 
December 31, 2013
 
Millions of Dollars
Assets
 
 
 
Cash Equivalents(1)
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

Restricted Cash(1)
2

 
2

 
—

 
—

 
—

 
2

Rabbi Trust Investments(2)
22

 
—

 
22

 
—

 
—

 
22

Energy Contracts - Regulatory Recovery(3)
2

 
—

 
1

 
1

 
(1
)
 
1

Total Assets
26

 
2

 
23

 
1

 
(1
)
 
25

Liabilities
 
 
 
 
 
 
 
 
 
 
 
Energy Contracts - Regulatory Recovery(3)
(2
)
 
—

 
—

 
(2
)
 
1

 
(1
)
Energy Contracts - Cash Flow Hedge(3)
(1
)
 
—

 
—

 
(1
)
 
—

 
(1
)
Interest Rate Swaps(4)
(7
)
 
—

 
(7
)
 
—

 
—

 
(7
)
Total Liabilities
(10
)
 
—

 
(7
)
 
(3
)
 
1

 
(9
)
Net Total Assets (Liabilities)
$
16

 
$
2

 
$
16

 
$
(2
)
 
$
—

 
$
16

(1) 
Cash Equivalents and Restricted Cash represent amounts held in money market funds and certificates of deposit valued at cost, including interest, which approximates fair market value. Cash Equivalents are included in Cash and Cash Equivalents on the balance sheets. Restricted Cash is included in Investments and Other Property – Other on the balance sheets.
(2) 
Rabbi Trust Investments include amounts related to deferred compensation and Supplement Executive Retirement Plan (SERP) benefits held in mutual and money market funds valued at quoted prices traded in active markets. These investments are included in Investments and Other Property – Other on the balance sheets.
(3) 
Energy Contracts include gas swap agreements (Level 2), power options (Level 2), gas options (Level 3), and forward power purchase and sales contracts (Level 3) entered into to reduce exposure to energy price risk. These contracts are included in Derivative Instruments on the balance sheets. The valuation techniques are described below.
(4) 
Interest Rate Swaps still held are valued based on the 6-month London Interbank Offered Rate (LIBOR). An interest rate swap valued based on the Securities Industry and Financial Markets Association Municipal swap index matured in September 2014. These interest rate swaps are included in Derivative Instruments on the balance sheets.
(5) 
All energy contracts are subject to legally enforceable master netting arrangements to mitigate credit risk. We have presented the effect of offset by counterparty; however, we present derivatives on a gross basis on the balance sheets.
DERIVATIVE INSTRUMENTS
We enter into various derivative and non-derivative contracts to reduce our exposure to energy price risk associated with our gas and purchased power requirements. The objectives for entering into such contracts include: creating price stability; meeting load and reserve requirements; and reducing exposure to price volatility that may result from delayed recovery under the PPFAC.
We primarily apply the market approach for recurring fair value measurements. When we have observable inputs for substantially the full term of the asset or liability or use quoted prices in an inactive market, we categorize the instrument in Level 2. We categorize derivatives in Level 3 when we use an aggregate pricing service or published prices that represent a consensus reporting of multiple brokers.
For both power and gas prices we obtain quotes from brokers, major market participants, exchanges, or industry publications and rely on our own price experience from active transactions in the market. We primarily use one set of quotations each for power and for gas and then validate those prices using other sources. We believe that the market information provided is reflective of market conditions as of the time and date indicated.
Published prices for energy derivative contracts may not be available due to the nature of contract delivery terms such as non-standard time blocks and non-standard delivery points. In these cases, we apply adjustments based on historical price curve relationships, transmission, and line losses.
We estimate the fair value of our gas options using a Black-Scholes-Merton option pricing model which includes inputs such as implied volatility, interest rates, and forward price curves. In the first half of 2013, we also used this pricing model to value our power options.
We also consider the impact of counterparty credit risk using current and historical default and recovery rates, as well as our own credit risk using credit default swap data.
The inputs and our assessments of the significance of a particular input to the fair value measurements require judgment and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels. We review the assumptions underlying our price curves monthly.
Cash Flow Hedges
We enter into interest rate swaps to mitigate the exposure to volatility in variable interest rates on debt. The interest rate swap agreements expire through January 2020. We also have a power purchase swap to hedge the cash flow risk associated with a long-term power supply agreement. The power purchase swap agreement expires in September 2015. The after-tax unrealized gains and losses on cash flow hedge activities and amounts reclassified to earnings are reported in the statements of other comprehensive income and Note 11. The loss expected to be reclassified to earnings within the next twelve months is estimated to be $2 million.
Financial Impact of Energy Contracts
We record unrealized gains and losses on energy contracts that are recoverable through the PPFAC on the balance sheets as a regulatory asset or a regulatory liability rather than reporting the transaction in the income statements or in the statements of other comprehensive income, as shown in following tables:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
 
Millions of Dollars
Unrealized Net Gain (Loss) Recorded to Regulatory (Assets)/Liabilities
$
(6
)
 
$
(1
)
 
$
(4
)
 
$
(2
)
Realized gains and losses on settled contracts are fully recoverable through the PPFAC. At September 30, 2014, we have energy contracts that will settle through the third quarter of 2017.
Derivative Volumes
The volumes associated with our energy contracts were as follows:
 
 
September 30, 2014
 
December 31, 2013
Power Contracts GWh
 
842

 
779

Gas Contracts GBtu
 
20,595

 
9,615


Level 3 Fair Value Measurements
The following table provides quantitative information regarding significant unobservable inputs in TEP’s Level 3 fair value measurements:
 
 
 
Fair Value at 
 
 
 
 
 
 
 
Valuation
 
September 30, 2014
 
 
 
Range of
 
Approach
 
Assets
 
Liabilities
 
Unobservable Inputs
 
Unobservable Input
 
 
 
Millions of Dollars
 
 
 
 
 
 
Forward Power Contracts
Market approach
 
$
—

 
$
(3
)
 
Market price per MWh
 
$
27.50

 
$
43.50


 
 
 
 
 
 
 
 
 
 
 
Gas Option Contracts
Option model
 
—

 
(1
)
 
Market price per MMbtu
 
$
3.67

 
$
4.24


 
 
 
 
 
 
Gas volatility
 
24.88
%
 
40.62
%
Level 3 Energy Contracts
 
 
$
—

 
$
(4
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fair Value at 
 
 
 
 
 
 
 
Valuation
 
December 31, 2013
 
 
 
Range of
 
Approach
 
Assets
 
Liabilities
 
Unobservable Inputs
 
Unobservable Input
 
 
 
Millions of Dollars
 
 
 
 
 
 
Forward Power Contracts
Market approach
 
$
—

 
$
(3
)
 
Market price per MWh
 
$
27.00

 
$
48.25

 
 
 
 
 
 
 
 
 
 
 
 
Gas Option Contracts
Option model
 
1

 
—

 
Market price per MMbtu
 
$
3.88

 
$
4.32

 
 
 
 
 
 
 
Gas volatility
 
25.05
%
 
35.07
%
Level 3 Energy Contracts
 
 
$
1

 
$
(3
)
 
 
 
 
 
 
 
Changes in one or more of the unobservable inputs could have a significant impact on the fair value measurement depending on the magnitude of the change and the direction of the change for each input. The impact of changes to fair value, including changes from unobservable inputs, are subject to recovery or refund through the PPFAC mechanism and are reported as a regulatory asset or regulatory liability, or as a component of other comprehensive income, rather than in the income statement.
The following tables present a reconciliation of changes in the fair value of assets and liabilities classified as Level 3 in the fair value hierarchy:
 
 
Three Months Ended September 30,
 
 
2014
 
2013
 
 
Millions of Dollars
Balances at June 30
 
$
—

 
$
(1
)
Realized/Unrealized Gains/(Losses) Recorded to:
 
 
 
 
Net Regulatory Assets/Liabilities – Derivative Instruments
 
(4
)
 
(1
)
Settlements
 
—

 
—

Balances at September 30
 
$
(4
)
 
$
(2
)
 
 
 
 
 
Total Gains/(Losses) Attributable to the Change in Unrealized Gains/(Losses) Relating to Assets/(Liabilities) Still Held at the End of the Period
 
$
(2
)
 
$
—

 
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
 
Millions of Dollars
Balances at December 31
 
$
(2
)
 
$
—

Realized/Unrealized Gains/(Losses) Recorded to:
 
 
 
 
Net Regulatory Assets/Liabilities – Derivative Instruments
 
(3
)
 
(2
)
Settlements
 
1

 
—

Balances at September 30
 
$
(4
)
 
$
(2
)
 
 
 
 
 
Total Gains/(Losses) Attributable to the Change in Unrealized Gains/(Losses) Relating to Assets/(Liabilities) Still Held at the End of the Period
 
$
(2
)
 
$
(1
)

CREDIT RISK
The use of contractual arrangements to manage the risks associated with changes in energy commodity prices creates credit risk exposure resulting from the possibility of non-performance by counterparties pursuant to the terms of their contractual obligations. We enter into contracts for the physical delivery of energy and gas which contain remedies in the event of non-performance by the supply counterparties. In addition, volatile energy prices can create significant credit exposure from energy market receivables and subsequent measurement at fair value.
We have contractual agreements for energy procurement and hedging activities that contain certain provisions requiring each company to post collateral under certain circumstances. These circumstances include: exposures in excess of unsecured credit limits provided to the Regulated Utilities; credit rating downgrades; or a failure to meet certain financial ratios. In the event that such credit events were to occur, we would have to provide certain credit enhancements in the form of cash or LOCs to fully collateralize our exposure to these counterparties.
We consider the effect of counterparty credit risk in determining the fair value of derivative instruments that are in a net asset position after incorporating collateral posted by counterparties and allocate the credit risk adjustment to individual contracts. We also consider the impact of our own credit risk after considering collateral posted on instruments that are in a net liability position and allocate the credit risk adjustment to all individual contracts.
Material adverse changes could trigger credit risk-related contingent features. At September 30, 2014, the value of derivative instruments in a net liability position under contracts with credit risk-related contingent features, including contracts under the normal purchase normal sale exception, was $17 million. At September 30, 2014 , TEP had no cash collateral posted and less than $1 million LOCs as credit enhancements with its counterparties and did not hold any collateral from its counterparties. The additional collateral to be posted if credit-risk contingent features were triggered would be $17 million.
FINANCIAL INSTRUMENTS NOT CARRIED AT FAIR VALUE
The fair value of a financial instrument is the market price to sell an asset or transfer a liability at the measurement date. We use the following methods and assumptions for estimating the fair value of our financial instruments:
•
The carrying amounts of our current maturities of long-term debt and amounts outstanding under our credit agreements approximate the fair values due to the short-term nature of these financial instruments. These items have been excluded from the table below.
•
For Investment in Lease Equity, we estimate the price at which an investor would realize a target internal rate of return. Our estimates include: the mix of debt and equity an investor would use to finance the purchase; the cost of debt; the required return on equity; and income tax rates. The estimate assumes a residual value based on an appraisal of Springerville Unit 1 conducted in 2011. No impairment has been recorded as TEP expects to recover the full carrying value in retail rates.
•
For Long-Term Debt, we use quoted market prices, when available, or calculate the present value of remaining cash flows at the balance sheet date. When calculating present value, we use current market rates for bonds with similar characteristics such as credit rating and time-to-maturity. We consider the principal amounts of variable rate debt outstanding to be reasonable estimates of the fair value. We also incorporate the impact of our own credit risk using a credit default swap rate.
The use of different estimation methods and/or market assumptions may yield different estimated fair value amounts. The carrying values recorded on the balance sheets and the estimated fair values of our financial instruments include the following:
 
 
 
September 30, 2014
 
December 31, 2013
 
Fair Value
Hierarchy
 
Carrying
Value
 
Fair
Value
 
Carrying
Value
 
Fair
Value
 
 
 
Millions of Dollars
Assets:
 
 
 
 
 
 
 
 
 
Investment in Lease Equity
Level 3
 
$
36

 
$
26

 
$
36

 
$
25

Liabilities:
 
 
 
 
 
 
 
 
 
Long-Term Debt
Level 2
 
1,372

 
1,444

 
1,223

 
1,214