REGULATORY MATTERS

The Arizona Corporation Commission (ACC) and the Federal Energy Regulatory Commission (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

Provisions of the 2017 Rate Order, which were effective February 27, 2017, include, but are not limited to:


•	a non-fuel base rate increase of $81.5 million; and


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

The ACC deferred matters related to net metering and rate design for new DG customers to a second phase of TEP’s rate case (Phase 2).

Phase 2 Order

On September 20, 2018, the ACC issued an order establishing, among other things, an export rate that replaced net metering for excess solar generation (Phase 2 Order). Residential and small commercial customers who apply to interconnect their solar generation systems to TEP's distribution system after the date of the order will no longer qualify for net metering. Customers who applied before the date of the order were grandfathered under previous net metering rules for a period of 20 years from the date of interconnection of their solar generation system.

Provisions of the Phase 2 Order for new DG customers include:


•	an option to select from existing Time-of-Use rate schedules;


•	a monthly bill credit for customer solar generation exported to TEP's grid calculated using an export rate approved by the ACC; and


•	an annual update to the export rate based on TEP's actual solar PPA and generation facilities costs, which are expected to decline. The export rate at the time of customers' applications to interconnect will be locked for 10 years. The initial export rate was set at 9.64 cents per kilowatt-hour (kWh).

FEDERAL TAX LEGISLATION

Arizona Corporation Commission

In December 2017, the ACC opened a docket requesting that all regulated utilities submit proposals to address passing the benefits of the TCJA through to customers. In April 2018, the ACC approved TEP’s proposal (ACC Refund Order) to return the savings from the Company’s federal income tax reduction under the TCJA to its customers through a combination of a customer bill credit and a regulatory liability that reflects the deferral of a portion of the savings to be returned to customers in TEP's next rate case, which is expected to be filed in 2019. The ACC Refund Order was effective May 1, 2018.

As a result of the ACC Refund Order, the Company will use a bill credit in 2018 to refund to customers: (i) $27.5 million related to the reduction in the federal corporate income tax rate; and (ii) $9 million related to an estimate of Excess Deferred Income Taxes (EDIT) amortization. The customer bill credit will be trued-up annually to reflect actuals for kWh sales and EDIT amortization. TEP recognized a reduction in Operating Revenues on the Condensed Consolidated Statements of Income of $12 million and $29 million in the three and nine months ended September 30, 2018, respectively. TEP's regulatory liability balance related to the ACC Refund Order was $1 million as of September 30, 2018. See Note 11 for additional information regarding the TCJA.

Federal Energy Regulatory Commission

In March 2018, the FERC issued an order directing TEP to either: (i) submit proposed revisions to its stated transmission rates or stated transmission revenue requirements to reflect the change in the federal corporate income tax rate as a result of the TCJA; or (ii) show cause why it should not be required to do so (FERC Refund Order). In May 2018, TEP responded to the order and proposed an overall transmission rate reduction of approximately 5.3%, reflecting the lower federal tax rate, to be effective March 21, 2018. As a result, TEP recognized a reduction in Operating Revenues on the Condensed Consolidated Statements of Income of $1 million in the nine months ended September 30, 2018. The transmission rate reduction did not have a material impact on TEP's financial position or results of operations in the three months ended September 30, 2018. TEP cannot predict the outcome of the order.

Also in March 2018, the FERC issued a Notice of Inquiry (NOI) regarding the effect of the TCJA. The NOI seeks comments on a number of issues including how to reflect the amortization of the EDIT regulatory liability balances in rates. TEP cannot predict the impact of the NOI.

See Note 11 for additional information regarding the TCJA.

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 Purchased Power and Fuel Adjustment Clause (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 rates designed to allow a regulated utility recovery of its costs of providing services and an opportunity to earn a reasonable return on its investment (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 $20 million as of September 30, 2018, and by $9 million as of December 31, 2017.

The table below presents TEP's PPFAC rates approved by the ACC:



Period	Cents per kWh
May 2018 through March 2019	0.20
March 2017 through April 2018⁽¹⁾	(0.20	)
May 2016 through February 2017	0.15


⁽¹⁾	In February 2017, the ACC approved a PPFAC credit to begin returning the over-collected PPFAC bank balance to customers until the effective date of the 2018 PPFAC rate.

Renewable Energy Standard

The ACC’s Renewable Energy Standard (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 are required to file an annual RES implementation plan for review and approval by the ACC.

In January 2018, the ACC approved TEP's 2018 RES implementation plan with a budget amount of $54 million, which is recovered 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; and (iii) various other program costs.

Energy Efficiency Standards

TEP is required to implement cost-effective Demand Side Management (DSM) programs to comply with the ACC's Energy Efficiency Standards (EE Standards). The EE Standards provide regulated utilities a DSM surcharge to recover from retail customers the costs to implement DSM programs, as well as an annual performance incentive. Energy savings realized through the programs count toward meeting the EE Standards and the associated lost revenues are partially recovered through the Lost Fixed Cost Recovery (LFCR) mechanism.

TEP earns the DSM performance incentive by meeting objectives stated in its energy efficiency implementation plan. The Company records its annual DSM performance incentive for the prior calendar year in the first quarter of each year. TEP recorded $2 million in 2018 and 2017 related to performance in Operating Revenues on the Condensed Consolidated Statements of Income.

In August 2017, TEP submitted its application for the 2018 energy efficiency implementation plan with a budget of $23 million and requested a waiver of the 2018 EE Standard. TEP expects to receive a decision on its 2018 energy efficiency implementation plan by the end of 2018. In May 2018, TEP notified the ACC that it would file an application for a 2019 energy efficiency implementation plan within 60 days of the approval of the 2018 energy efficiency implementation plan.

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 customer-installed DG. 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 2% of TEP's applicable retail revenues, as approved in the 2017 Rate Order.

TEP recorded regulatory assets and recognized LFCR revenues of $5 million and $18 million in the three and nine months ended September 30, 2018, respectively, and $6 million and $17 million in the three and nine months ended September 30, 2017, respectively. LFCR revenues are included in Operating Revenues on the Condensed Consolidated Statements of Income.

REGULATORY ASSETS AND LIABILITIES

Regulatory assets and liabilities recorded in the balance sheet are summarized in the table below:



($ in millions)	Remaining Recovery Period (years)	September 30, 2018		December 31, 2017
Regulatory Assets
Pension and Other Postretirement Benefits	Various	$	121	$	126
Early Generation Retirement Costs ⁽¹⁾	Various	74		84
Income Taxes Recoverable through Future Rates	Various	43		40
Derivatives	3	42		18
Final Mine Reclamation and Retiree Healthcare Costs ⁽²⁾	19	33		31
Lost Fixed Cost Recovery	2	32		29
Property Tax Deferrals	1	25		24
Springerville Unit 1 Leasehold Improvements⁽³⁾	5	12		14
Other Regulatory Assets	Various	22		22
Total Regulatory Assets		404		388
Less Current Portion	1	110		94
Total Non-Current Regulatory Assets		$	294	$	294



Regulatory Liabilities
Income Taxes Payable through Future Rates ⁽⁴⁾	Various	$	346	$	353
Net Cost of Removal ⁽⁵⁾	Various	169		180
Renewable Energy Standard	Various	52		44
Purchased Power and Fuel Adjustment Clause	1	20		9
Deferred Investment Tax Credits	Various	8		14
Other Regulatory Liabilities	Various	9		5
Total Regulatory Liabilities		604		605
Less Current Portion	1	110		89
Total Non-Current Regulatory Liabilities		$	494	$	516


⁽¹⁾	Includes the net book value and other related costs of Navajo Generating Station (Navajo) and H. Wilson Sundt Generating Station (Sundt) Units 1 and 2 reclassified from Utility Plant, Net on the Condensed Consolidated Balance Sheets due to the planned early retirement of the facilities. Navajo and Sundt Units 1 and 2 are being fully recovered in base rates using various useful lives through 2030.


⁽²⁾	Represents costs associated with TEP’s jointly-owned facilities at San Juan, Four Corners Generating Station (Four Corners), and Navajo. TEP recognizes these costs at future value and is permitted to recover these costs on a pay-as-you-go basis through the PPFAC mechanism. The majority of final mine reclamation costs are expected to occur through 2037.


⁽³⁾	Represents investments TEP made, which were previously recorded in Plant in Service on the Condensed Consolidated Balance Sheets, to ensure that the facilities continued to provide service to TEP's customers. TEP received ACC authorization to recover leasehold improvement costs at Springerville Unit 1 over a 10-year amortization period.

⁽⁴⁾

Includes balances related to EDIT as a result of the revaluation of deferred income taxes in 2017 due to the TCJA. TEP is amortizing the EDIT balances in accordance with applicable federal income tax laws, which require the amortization of a majority of the balance over the remaining life of the related asset. In April 2018, the ACC Refund Order was approved requiring TEP to return EDIT amortization of the ACC-jurisdictional assets with customers. See Note 11 for additional information regarding the TCJA.


⁽⁵⁾	Represents an estimate of the future cost of retirement net of salvage value. These are amounts collected through revenue for transmission, distribution, and generation plant and general and intangible plant which are not yet expended.

Regulatory assets are either being collected or are expected to be collected through Retail Rates. With the exception of Early Generation Retirement Costs and Springerville Unit 1 Leasehold Improvements, 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 and Income Taxes Payable through Future Rates related to the EDIT balances, TEP does not pay a return on regulatory liabilities.

FERC COMPLIANCE

In 2016, the FERC issued orders relating to certain late-filed transmission service agreements (TSAs), which resulted in TEP paying time-value refunds to the counterparties of these TSAs. In January 2017, TEP and one of the TSA counterparties entered into a settlement agreement resulting in the counterparty paying TEP $8 million. The settlement amount was recorded in Other, Net on the Condensed Consolidated Statements of Income. As a result of the settlement, TEP dismissed a previously filed appeal. In May 2017, the FERC informed TEP that the related investigation was closed. As management no longer believed a loss was probable, TEP reversed the $5 million remaining balance related to potential time-value refunds in Current Liabilities—Other on the Condensed Consolidated Balance Sheets offsetting Operating Revenues on the Condensed Consolidated Statements of Income.