REGULATORY MATTERS

The ACC and the FERC each regulate portions of utility accounting practices and rates of TEP. The ACC regulates rates charged to retail customers, the siting of generation and transmission facilities, the issuance of securities, transactions with affiliated parties, and other utility matters. The ACC also enacts other regulations and policies that can affect business decisions and accounting practices. The FERC regulates terms and prices of transmission services and wholesale electricity sales.

2017 RATE ORDER

In February 2017, the ACC issued a rate order in the rate case filed by TEP in November 2015. TEP's rate filing was based on a test year ended June 30, 2015. The 2017 Rate Order approved new rates to be effective on or before March 1, 2017.

The provisions of the 2017 Rate Order include, but are not limited to:


•	a non-fuel base rate increase of $81.5 million, which includes $15 million of operating costs related to the 50.5% undivided interest in Springerville Unit 1 purchased by TEP in September 2016;


•	a 7.04% return on original cost rate base, which includes a cost of equity component of 9.75% and a cost of debt component of 4.32%; and


•	adoption of TEP's proposed depreciation and amortization rates, which include a reduction in the depreciable life for San Juan Unit 1.

The ACC deferred TEP's proposed changes to net metering and rate design for new DG customers to Phase 2, which is expected to begin in the second quarter of 2017. TEP cannot predict the outcome of this proceeding.

COST RECOVERY MECHANISMS

TEP has received regulatory decisions that allow for more timely recovery of certain costs through the recovery mechanisms described below.

Purchased Power and Fuel Adjustment Clause

TEP's PPFAC rate is adjusted annually each April 1st and goes into effect for the subsequent 12-month period unless modified by the ACC. The PPFAC rate includes: (i) a forward component which is calculated by taking the difference between forecasted fuel and purchased power costs and the amount of those costs established in Retail Rates; and (ii) a true-up component that reconciles the difference between actual costs and those recovered in the preceding 12-month period. The PPFAC bank balance was over-collected by $38 million and $18 million as of December 31, 2016 and 2015, respectively.

In February 2017, the ACC approved in the 2017 Rate Order a PPFAC credit to begin returning the over-collected balance to customers. The table below presents TEP's PPFAC rates approved by the ACC:



Period	Cents per kWh
March 2017 through March 2018	(0.20	)
May 2016 through February 2017	0.15
April 2015 through April 2016	0.68
October 2014 through March 2015	0.50
May 2014 through September 2014	0.10
July 2013 through April 2014	(0.14	)

Renewable Energy Standard

The ACC’s RES requires Arizona regulated utilities to increase their use of renewable energy each year until it represents at least 15% of their total annual retail energy requirements by 2025, with DG accounting for 30% of the annual renewable energy requirement. Arizona utilities must file an annual RES implementation plan for review and approval by the ACC.

In May 2016, the ACC approved TEP's 2016 RES implementation plan of $57 million, which was partially offset by applying approximately $9 million of previously recovered carryover funds. TEP has been approved to recover the remaining $48 million through the RES surcharge. The recovery funds the following: (i) the above market cost of renewable power purchases; (ii) previously awarded performance-based incentives for customer installed DG; (iii) depreciation and a return on certain TEP investments in company-owned solar projects; and (iv) various other program costs. TEP recognized approximately $3 million of revenue in 2016 as a return on company-owned solar projects. TEP suspended its rooftop solar program effective December 2016, but requested approval of a community solar program. The ACC is expected to consider this program in Phase 2.

In July 2016, TEP submitted its application for the 2017 RES implementation plan with a budget amount of $54 million. TEP expects to recover less than $1 million of revenue in 2017 through the RES surcharge as a return on certain company-owned solar projects. This amount reflects the return and related recovery on projects that are not included in TEP’s Retail Rates. In addition, TEP is no longer requesting recovery on company-owned solar projects through the RES mechanism. TEP expects to receive a decision on its 2017 RES implementation plan in the first half of 2017.

The percentage of retail kWh sales attributable to the 2016 RES renewable energy requirement was approximately 10%, exceeding the overall 2016 requirement of 6%. Compliance is determined through the ACC's review of TEP's annual RES implementation plan. As TEP no longer pays incentives to obtain distributed generation RECs, which are used to demonstrate compliance with the DG requirement, the ACC approved a waiver of the 2016 and 2017 residential DG requirement.

Energy Efficiency Standards

Under the EE Standards, the ACC requires electric utilities to implement cost-effective programs to reduce customers' energy consumption. The EE Standards require increasing cumulative annual targeted retail kWh savings equal to 22% by 2020. As of December 2016, TEP’s cumulative annual energy savings were approximately 12%. TEP’s compliance with the EE Standards is governed by the ACC’s approval of its annual implementation plan.

TEP is required to implement cost-effective DSM programs to comply with the ACC's EE Standards. The EE Standards provide for a DSM surcharge for regulated utilities to recover from retail customers the costs to implement DSM programs as well as an annual performance incentive. TEP records its annual DSM performance incentive for the prior calendar year in the first quarter of each year. TEP recorded $2 million in 2016, $3 million in 2015, and $2 million in 2014 related to performance, included in Retail Revenues on the Consolidated Statements of Income.

In February 2016, the ACC approved TEP's 2016 energy efficiency implementation plan, including recovery of approximately $14 million from retail customers for new and existing DSM programs. Energy savings realized through the programs will count toward meeting the EE Standards and the associated lost revenue will be partially recovered through the LFCR mechanism. TEP notified the ACC that it would not file a 2017 implementation plan and will continue its 2016 plan through the end of 2017 without change. TEP will file its 2018 implementation plan by June 1, 2017.

Lost Fixed Cost Recovery Mechanism

The LFCR mechanism provides for recovery of certain non-fuel costs that would go unrecovered due to reduced retail kWh sales as a result of implementing ACC-approved energy efficiency programs and meeting distributed generation targets. TEP records a regulatory asset and recognizes LFCR revenues when the amounts are verifiable regardless of when the lost retail kWh sales occur. TEP is required to make an annual filing with the ACC requesting recovery of the LFCR revenues recognized in the prior year. The recovery is subject to a year-over-year cap of 1% of TEP's applicable retail revenues.

TEP recorded a regulatory asset and recognized LFCR revenues of $18 million in 2016, $12 million in 2015, and $11 million in 2014. LFCR revenues are included in Retail Revenues on the Consolidated Statements of Income.

Appellate Review of Rate Decisions

In a 2015 appellate challenge to two ACC rate decisions regarding a water company, the Court of Appeals for the State of Arizona considered the issue of how the ACC should determine a utility’s “fair value,” as specified in the Arizona Constitution, in connection with authorizing recovery of costs through rate adjustors outside of a rate case. The Court reversed the ACC’s method of finding fair value in that case and raised questions concerning the relationship between the need for fair value findings and the recovery of capital and certain other utility costs through adjustors. In February 2016, the Arizona Supreme Court granted the ACC’s request for review of this decision. In August 2016, the Supreme Court vacated the Court of Appeals decision and confirmed the ACC’s decision regarding the rate adjustor at issue.

FERC COMPLIANCE

In 2016, the FERC issued orders relating to certain late-filed TSAs, which resulted in TEP recording $22 million in time value refunds in 2016. See Note 7 for additional information related to FERC compliance associated with these transmission contracts.

REGULATORY ASSETS AND LIABILITIES

Regulatory assets are either being collected or are expected to be collected through Retail Rates. With the exception of the leasehold improvements at Springerville Unit 1 and the coal handling facilities at Sundt, TEP does not earn a return on regulatory assets. Regulatory liabilities represent items that TEP either expects to pay to customers through billing reductions in future periods or plans to use for the purpose for which they were collected from customers. With the exception of over-recovered PPFAC costs, TEP does not pay a return on regulatory liabilities. The regulatory assets and liabilities recorded in the Consolidated Balance Sheets are summarized in the table below:



	Remaining Recovery Period (years)	December 31,
(dollars in millions)	Remaining Recovery Period (years)	2016		2015
Regulatory Assets
Pension and Other Postretirement Benefits (Note 8)	Various	$	128	$	120
Income Taxes Recoverable through Future Rates ⁽¹⁾	Various	29		26
Final Mine Reclamation and Retiree Health Care Costs ⁽²⁾	21	27		28
Property Tax Deferrals ⁽³⁾	1	23		21
Lost Fixed Cost Recovery	1	23		16
Springerville Unit 1 Leasehold Improvements ⁽⁴⁾	7	17		21
Sundt Coal Handling Facilities ⁽⁵⁾	Plant Life	16		—
Derivatives (Note 11)	3	2		12
Other Regulatory Assets	Various	16		20
Total Regulatory Assets		281		264
Less Current Portion	1	56		52
Total Non-Current Regulatory Assets		$	225	$	212



Regulatory Liabilities
Net Cost of Removal for Interim Retirements ⁽⁶⁾	Various	$	270	$	264
Purchased Power and Fuel Adjustment Clause	1	38		18
Renewable Energy Standard	Various	32		25
Deferred Investment Tax Credits ⁽⁷⁾	Various	23		32
Other Regulatory Liabilities	Various	14		21
Total Regulatory Liabilities		377		360
Less Current Portion	1	76		53
Total Non-Current Regulatory Liabilities		$	301	$	307


⁽¹⁾	Income Taxes Recoverable through Future Rates are amortized over the life of the assets. See Note 1 and Note 12 for additional information regarding income taxes.


⁽²⁾	Final Mine Reclamation and Retiree Health Care Costs represent costs associated with TEP’s jointly-owned facilities at San Juan, Four Corners, and Navajo. TEP recognizes these costs at future value and is permitted to fully recover these costs through the PPFAC when paid. The majority of the final mine reclamation costs are expected to occur through 2037.

⁽³⁾

Property taxes are recorded as a regulatory asset based on historical ratemaking treatment allowing regulated utilities to recover property taxes on a pay-as-you-go or cash basis. TEP records a liability to reflect the accrual for financial reporting purposes and an offsetting regulatory asset to reflect recovery for regulatory purposes. This asset is fully recovered in rates with a recovery period of approximately six months.


⁽⁴⁾	Springerville Unit 1 Leasehold Improvements represent investments TEP made, which were previously recorded in Plant in Service on the Consolidated Balance Sheets, to ensure that the facilities continued to provide safe, reliable service to TEP's customers. TEP received ACC authorization to recover leasehold improvement costs at Springerville Unit 1 over a 10-year amortization period.

⁽⁵⁾

In June 2014, the EPA issued a final rule that required TEP to either: (i) install, by mid-2017, SNCR and dry sorbent injection if Sundt Unit 4 continued to use coal as a fuel source; or (ii) permanently eliminate coal as a fuel source as a better-than-BART alternative by the end of 2017. In March 2016, TEP notified the EPA of its decision to permanently eliminate coal as a fuel source, and transferred the NBV of the Sundt Coal Handling Facilities to a regulatory asset. TEP will apply excess depreciation reserves against the unrecovered NBV as approved in the 2017 Rate Order.


⁽⁶⁾	Net Cost of Removal for Interim Retirements represents an estimate of the cost of future AROs net of salvage value. These are amounts collected through revenue for the net cost of removal of interim retirements for transmission, distribution, generation plant, and general and intangible plant which are not yet expended.


⁽⁷⁾	Accumulated Deferred Investment Tax Credits (ITC) represent federal energy credits generated after 2011 that are amortized over the tax life of the underlying asset.

IMPACTS OF REGULATORY ACCOUNTING

If TEP determines that it no longer meets the criteria for continued application of regulatory accounting, TEP would be required to write off its regulatory assets and liabilities related to those operations not meeting the regulatory accounting requirements. Discontinuation of regulatory accounting could have a material impact on TEP's financial statements.