FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS

TEP categorizes financial instruments 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 classified in their entirety based on the lowest level of input that is significant to the fair value measurement:



	Level 1		Level 2			Level 3			Total
(in millions)	December 31, 2017
Assets
Cash Equivalents⁽¹⁾	$	30	$	—		$	—		$	30
Restricted Cash⁽¹⁾	12		—			—			12
Energy Derivative Contracts, Regulatory Recovery⁽²⁾	—		9			—			9
Energy Derivative Contracts, No Regulatory Recovery⁽²⁾	—		—			3			3
Total Assets	42		9			3			54
Liabilities
Energy Derivative Contracts, Regulatory Recovery⁽²⁾	—		(26		)	—			(26		)
Energy Derivative Contracts, No Regulatory Recovery⁽²⁾	—		—			(1		)	(1		)
Interest Rate Swap⁽³⁾	—		(1		)	—			(1		)
Total Liabilities	—		(27		)	(1		)	(28		)
Total Assets (Liabilities), Net	$	42	$	(18	)	$	2		$	26



(in millions)	December 31, 2016
Assets
Cash Equivalents⁽¹⁾	$	23	$	—		$	—		$	23
Restricted Cash⁽¹⁾	7		—			—			7
Energy Derivative Contracts, Regulatory Recovery⁽²⁾	—		3			—			3
Energy Derivative Contracts, No Regulatory Recovery⁽²⁾	—		—			2			2
Total Assets	30		3			2			35
Liabilities
Energy Derivative Contracts, Regulatory Recovery⁽²⁾	—		(2		)	(1		)	(3		)
Interest Rate Swap⁽³⁾	—		(2		)	—			(2		)
Total Liabilities	—		(4		)	(1		)	(5		)
Total Assets (Liabilities), Net	$	30	$	(1	)	$	1		$	30

⁽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 Consolidated Balance Sheets. Restricted Cash is included in Investments and Other Property and in Current Assets—Other on the Consolidated Balance Sheets.


⁽²⁾	Energy Derivative Contracts include gas swap agreements (Level 2) and forward purchased power and sales contracts (Level 3) entered into to reduce exposure to energy price risk. These contracts are included in Derivative Instruments on the Consolidated Balance Sheets. The valuation techniques are described below.


⁽³⁾	The Interest Rate Swap is valued using an income valuation approach based on the 6-month LIBOR and is included in Derivative Instruments on the Consolidated Balance Sheets.

All energy derivative contracts are subject to legally enforceable master netting arrangements to mitigate credit risk. TEP presents derivatives on a gross basis in the balance sheet. The tables below present the potential offset of counterparty netting and cash collateral.



	Gross Amount Recognized in the Balance Sheets			Gross Amount Not Offset in the Balance Sheets					Net Amount
	Gross Amount Recognized in the Balance Sheets			Counterparty Netting of Energy Contracts			Cash Collateral Received/Posted		Net Amount
(in millions)	December 31, 2017
Derivative Assets
Energy Derivative Contracts	$	12		$	10		$	—	$	2
Derivative Liabilities
Energy Derivative Contracts	(27		)	(10		)	—		(17		)
Interest Rate Swap	(1		)	—			—		(1		)



(in millions)	December 31, 2016
Derivative Assets
Energy Derivative Contracts	$	5		$	2		$	—	$	3
Derivative Liabilities
Energy Derivative Contracts	(3		)	(2		)	—		(1		)
Interest Rate Swap	(2		)	—			—		(2		)

DERIVATIVE INSTRUMENTS

TEP enters into various derivative and non-derivative contracts to reduce exposure to energy price risk associated with its natural gas and purchased power requirements. The objectives for entering into such contracts include: (i) creating price stability; (ii) meeting load and reserve requirements; and (iii) reducing exposure to price volatility that may result from delayed recovery under the PPFAC mechanism.

The Company primarily applies the market approach for recurring fair value measurements. When TEP has observable inputs for substantially the full term of the asset or liability or uses quoted prices in an inactive market, it categorizes the instrument in Level 2. TEP categorizes derivatives in Level 3 when an aggregate pricing service or published prices that represent a consensus reporting of multiple brokers is used.

For both purchased power and natural gas prices, TEP obtains quotes from brokers, major market participants, exchanges, or industry publications and relies on its own price experience from active transactions in the market. The Company primarily uses one set of quotations each for purchased power and natural gas and then validates those prices using other sources. TEP believes 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, TEP applies adjustments based on historical price curve relationships, transmission costs, and line losses.

TEP also considers the impact of counterparty credit risk using current and historical default and recovery rates, as well as its own credit risk using credit default swap data.

The inputs and the Company's 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. TEP reviews the assumptions underlying its price curves monthly.

Cash Flow Hedges

To mitigate the exposure to volatility in variable interest rates on debt, TEP has an interest rate swap agreement that expires in January 2020. TEP had a purchased power swap to hedge the cash flow risk associated with a long-term power supply agreement which expired in September 2015. The after-tax unrealized gains and losses on cash flow hedge activities are reported in the statement of comprehensive income. The loss expected to be reclassified to earnings within the next twelve months is estimated to be $1 million.

Realized losses from cash flow hedges are shown in the following table:



	Years Ended December 31,
(in millions)	2017		2016		2015
Capital Lease Interest Expense	$	1	$	1	$	2
Purchased Power	—		—		1

As of December 31, 2017, the total notional amount of the interest rate swap was $18 million.

Energy Derivative Contracts, Regulatory Recovery

TEP records unrealized gains and losses on energy purchase contracts that are recoverable through the PPFAC mechanism on the balance sheet as a regulatory asset or a regulatory liability rather than reporting the transaction in the income statement or in the statement of other comprehensive income, as shown in the following table:



	Years Ended December 31,
(in millions)	2017			2016		2015
Unrealized Net Gain (Loss) Recorded to Regulatory (Assets) Liabilities	$	(18	)	$	12	$	6

Energy Derivative Contracts, No Regulatory Recovery

TEP enters into certain contracts that qualify as derivatives, but do not meet the regulatory recovery criteria. The Company records unrealized gains and losses for these contracts in the income statement unless a normal purchase or normal sale election is made. For contracts that meet the trading definition, as defined in the PPFAC plan of administration, TEP must share 10% of any realized gains with retail customers through the PPFAC mechanism.

Derivative Volumes

As of December 31, 2017, TEP has energy contracts that will settle on various expiration dates through 2029. The volumes associated with the energy contracts were as follows:



	December 31,
	2017	2016
Power Contracts GWh	2,589	2,610
Gas Contracts BBtu ⁽¹⁾	137,952	12,355


⁽¹⁾	Increase in volume of gas contracts is a result of the planned early retirement of certain coal-fired generation. To reduce exposure to energy price risk associated with natural gas, the Company entered into longer term gas contracts increasing its overall volume outstanding in 2017. See Note 3 for additional information related to the planned early retirement of coal-fired generation.

Level 3 Fair Value Measurements

The following tables provide quantitative information regarding significant unobservable inputs in TEP’s Level 3 fair value measurements:



	Valuation	Fair Value of						Range of
	Approach	Assets		Liabilities			Unobservable Inputs	Unobservable Input
(in millions)	December 31, 2017
Forward Power Contracts	Market approach	$	3	$	(1	)	Market price per MWh	$	17.65	$	34.60

(in millions)	December 31, 2016
Forward Power Contracts	Market approach	$	2	$	(1	)	Market price per MWh	$	20.90	$	40.00

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 table presents a reconciliation of changes in the fair value of net assets and liabilities classified as Level 3 in the fair value hierarchy and the gains (losses) attributable to the change in unrealized gains (losses) relating to assets (liabilities) still held at the end of the period:



	Years Ended December 31,
(in millions)	2017			2016
Beginning of Period	$	1		$	(2	)
Gains (Losses) Recorded
Regulatory Assets or Liabilities, Derivative Instruments	1			2
Wholesale Revenues	4			4
Settlements	(4		)	(3		)
End of Period	$	2		$	1

Gains (Losses), Assets (Liabilities) still held	$	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. TEP enters into contracts for the physical delivery of power and natural 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.

TEP has contractual agreements for energy procurement and hedging activities that contain certain provisions requiring TEP and its counterparties to post collateral under certain circumstances. These circumstances include: (i) exposures in excess of unsecured credit limits; (ii) credit rating downgrades; or (iii) a failure to meet certain financial ratios. In the event that such credit events were to occur, the Company, or its counterparties, would have to provide certain credit enhancements in the form of cash, a LOC, or other acceptable security to collateralize exposure beyond the allowed amounts.

TEP considers 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 then allocates the credit risk adjustment to individual contracts. TEP also considers the impact of its credit risk on instruments that are in a net liability position, after considering the collateral posted, and then allocates the credit risk adjustment to the individual contracts.

The value of all derivative instruments in net liability positions under contracts with credit risk-related contingent features, including contracts under the normal purchase normal sale exception, was $27 million as of December 31, 2017, compared with $8 million as of December 31, 2016. As of December 31, 2017, TEP had no LOCs as credit enhancements with its counterparties. If the credit risk contingent features were triggered on December 31, 2017, TEP would have been required to post an additional $27 million of collateral of which $12 million relates to outstanding net payable balances for settled positions.

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. TEP uses the following methods and assumptions for estimating the fair value of financial instruments:


•	Borrowings under revolving credit facilities approximate fair value due to the short-term nature of these financial instruments. These items have been excluded from the table below.

•

For long-term debt, TEP uses quoted market prices, when available, or calculates the present value of the remaining cash flows as of the balance sheet date. When calculating present value, the Company uses current market rates for bonds with similar characteristics such as credit rating and time-to-maturity. TEP considers the principal amounts of variable rate debt outstanding to be reasonable estimates of the fair value. The Company also incorporates the impact of its 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 following table includes the face value and estimated fair value of TEP's long-term debt:



	Fair Value Hierarchy	Face Value				Fair Value
		December 31,
(in millions)		2017		2016		2017		2016
Liabilities
Long-Term Debt, including Current Maturities	Level 2	$	1,466	$	1,466	$	1,547	$	1,472