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<div align="left" style="font-size: 10pt; margin-top: 10pt"><u><b>NOTE 6. COMMITMENTS AND CONTINGENCIES </b></u>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>TEP COMMITMENTS</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>Firm Purchase Commitments</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In 2010, TEP entered into new long-term, forward purchase power commitments in addition to those
reported in our 2009 Annual Report on Form 10-K. These contracts will settle in June 2011 through
September 2011 with prices that are indexed to natural gas prices. TEP’s estimated minimum
payment obligation for these purchases is $8 million based on projected market prices as of June
30, 2010.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>Renewable Energy Purchase Power Agreements</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In 2009, TEP entered into three 20 year long-term purchase power agreements with developing
renewable energy generation facilities. The ACC approved the agreements in April 2010. The
facilities are expected to begin commercial operation during 2011 or 2012. TEP is required to
purchase the full output of each facility for 20 years. Expected capacities range from 1.4 MW to
25 MW. TEP is only obligated to pay for actual energy delivered. There are no minimum payment
obligations under these contracts. TEP is authorized to recover a portion of the cost of renewable
energy through the PPFAC with the balance of cost recoverable through the REST surcharge.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In 2010, TEP entered into similar long-term renewable energy contracts for approximately 140 MW.
These agreements are subject to ACC approval of cost recovery, which is expected later in 2010.
These facilities are also expected to begin commercial operation during 2011 or 2012.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In June 2010, TEP entered into a $7 million contract for construction of a 1.6 MW solar
installation that is expected to be in service by the end of 2010. In July 2010, TEP entered into
a $7 million contract for a 1.8 MW solar installation in Springerville that is also expected to be
in service by the end of 2010. The ACC approved recovery of the revenue requirements associated
with these projects in May 2010.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>UNS ELECTRIC COMMITMENTS</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In 2010, UNS Electric entered into forward power purchase agreements through December 2012. UNS
Electric estimates its minimum payments for these forward purchases to be $15 million in 2011 and
$2 million in 2012. Certain of these purchased power contracts are at a fixed price per MWh and
others are indexed to natural gas prices. For indexed contracts, commitments are based on
projected market prices as of June 30, 2010.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In 2009, UNS Electric entered into a 20 year long-term purchase power agreement with a developing
renewable energy generation facility. The agreement was subject to ACC approval, which was
received in April 2010. The facility is expected to begin commercial operation in 2011. UNS
Electric is required to purchase the full output of
the facility for 20 years. The facility has an expected minimum capacity of 7 MW. UNS Electric is
only obligated to pay for actual energy delivered. There is no minimum payment obligation under
this contract. UNS Electric is authorized to recover a portion of the cost of renewable energy
through the PPFAC with the balance of cost recovery through the REST surcharge.
</div>
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<b>
</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>UNS GAS COMMITMENTS</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In 2010, UNS Gas entered into forward gas purchase agreements through May 2015. UNS Gas estimates
its minimum payments for these forward purchases to be $4 million in 2011 and 2012, $2 million in
2013 and less than $1 million in each of 2014 and 2015.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>UNISOURCE ENERGY COMMITMENTS</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In 2009, UniSource Energy purchased land to construct a new headquarters building in downtown
Tucson. In April 2010, UniSource Energy signed a design-build contract committing to a payment of
$14 million for the first phase of the construction project expected to be completed in the second
quarter of 2011.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>TEP CONTINGENCIES</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>El Paso Electric Transmission</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In 2006, El Paso filed a complaint with the FERC claiming that TEP must request service under El
Paso’s Open Access Transmission Tariff (OATT) in order to transmit power from Luna to TEP’s system.
TEP filed a counter complaint stating that TEP has existing rights under a 1982 Tucson-El Paso
Transmission Agreement and, therefore, is not required to pay for transmission service under El
Paso’s OATT. In November 2008, the FERC issued an order supporting TEP’s position. In December
2008, pending resolution, El Paso refunded to TEP $10 million paid for transmission service from
Luna during the period 2006 to 2008 and interest of $1 million. TEP is no longer accruing for
transmission service under El Paso’s OATT.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In July 2010, the FERC issued an order denying El Paso’s request for rehearing of FERC’s
November 2008 order. In July 2010, El Paso filed an appeal in the United States Court of Appeals
for the District of Columbia Circuit. TEP did not recognize income in the second quarter of 2010
as a result of the July FERC decision.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In December 2008, TEP filed a complaint in the United States Federal District Court against El Paso
seeking a $2 million reimbursement from El Paso for transmission charges paid by TEP to Public
Service Company of New Mexico (PNM) for transmission service in an attempt to mitigate TEP’s
damages before FERC issued its decision in November 2008. In September 2009, the District Court
denied El Paso’s motion to dismiss TEP’s complaint and stayed the proceeding pending a final
resolution of the FERC proceedings and any appeal. TEP cannot predict the timing or outcome of
this lawsuit.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>Claims Related to Navajo Generating Station</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In June 1999, the Navajo Nation filed suit against Salt River Project (SRP), several Peabody Coal
Company entities (including Peabody Western Coal Company (Peabody), the coal supplier to Navajo
Generating Station (Navajo), Southern California Edison Company, and other defendants in the U.S.
District Court for the District of Columbia (D.C. Lawsuit). Although TEP is not a named defendant
in the D.C. Lawsuit, TEP is a 7.5% participant in the Navajo. The D.C. Lawsuit alleges, among other
things, that the defendants obtained a favorable coal royalty rate on the lease agreements under
which Peabody mines coal by improperly influencing the outcome of a federal administrative process
pursuant to which the royalty rate was to be adjusted. The suit seeks $600 million in damages,
treble damages, punitive damages of not less than $1 billion, and the ejection of defendants from
all possessory interests and Navajo Tribal lands arising out of the primary coal lease. In July
2001, the District Court dismissed all claims against SRP. In March 2008, the District Court
lifted a stay that had been in place since October 2004 and referred pending discovery related
motions to a magistrate judge. In February 2010, the District Court extended the discovery
deadline and set other procedural deadlines at various dates between March 2010 and February 2011.
In April 2010, the Navajo Nation filed a Second Amended Complaint.
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</b>
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<div align="left" style="font-size: 10pt; margin-top: 10pt">In 2004, Peabody 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 arising out
of the D.C. Lawsuit. In July 2008, the parties entered into a joint stipulation of dismissal of
these claims which was approved by the Circuit Court. TEP cannot predict whether the lawsuit will
be refiled based upon the final outcome of the D.C. Lawsuit.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>Claims Related to San Juan Generating Station</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In December 2009, TEP received a Notice of Intent to Sue (RCRA Notice) under the Resource
Conservation and Recovery Act (RCRA) from the Sierra Club. The RCRA Notice was also sent to all San
Juan Generating Station (San Juan) owners, to San Juan Coal Company (SJCC), which operates the San Juan
mine that supplies coal to San Juan, and to SJCC parent BHP Minerals International Inc. (BHP).
Additionally, TEP was informed that in December 2009 SJCC and BHP received a separate Notice of
Intent to Sue under the Surface Mine Control and Reclamation Act (SMCRA) from the Sierra Club. In
April 2010, the Sierra Club filed a citizens suit under RCRA and SMCRA in the U.S. District Court
for the District of New Mexico against Public Service Company of New Mexico (PNM), as operator of
San Juan, PNM parent PNM Resources, Inc. (PNMR), SJCC and BHP. The Sierra Club alleges in the suit that
certain activities at San Juan and the San Juan mine associated with the treatment, storage and
disposal of coal and coal combustion by-products (CCBs) are causing imminent and substantial harm
to the environment, including ground and surface water in the region, and that placement of CCBs at
the mine constitute “open dumping” in violation of RCRA. The RCRA claims are asserted against PNM,
PNMR, SJCC and BHP. The suit also includes claims under SMCRA which are directed only against SJCC
and BHP. The suit seeks the following relief: an injunction requiring the parties to undertake
certain mitigation measures with respect to the placement of CCBs at the mine or to cease placement
of CCBs at the mine; the imposition of civil penalties; and, attorney’s fees and costs. None of the
defendants have been formally served with the complaint. On July 10, 2010, the Sierra Club filed an
amended complaint that corrected some technical deficiencies in its original complaint. The
factual allegations remained the same. PNM plans an aggressive defense of the RCRA claims in the
suit. As a 20% owner of San Juan, TEP is liable for its share of any resulting liabilities. TEP
cannot predict the outcome of this matter at this time.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">SJCC, the coal supplier to San Juan, through leases with the federal government and the State of New
Mexico, owns coal interests with respect to an underground mine that supplies coal to San Juan.
Certain gas producers have oil and gas leases with the federal government, the State of New Mexico
and private parties in the area of the underground mine. These gas producers allege that SJCC’s
underground coal mining operations have or will interfere with their gas production and will reduce
the amount of natural gas that they would otherwise be entitled to recover. SJCC has compensated
certain gas producers for any remaining gas production from a well when it was determined that
mining activity was close enough to warrant shutting down the well. These settlements, however, do
not resolve all potential claims by gas producers in the underground mine area. As a 20% owner of
San Juan, TEP is liable for its share of any resulting liabilities. TEP cannot estimate the impact
of any future claims by these gas producers on the cost of coal at San Juan.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>Regional Haze Findings</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">The EPA’s regional haze rules require emission controls known as Best Available Retrofit Technology
(BART) for certain industrial facilities emitting air pollutants that reduce visibility. The
rules call for all states to establish goals and emission reduction strategies for improving
visibility in national parks and wilderness areas and to submit a state implementation plan (SIP)
to the EPA. In June 2010, the New Mexico Environment Department (NMED) filed its proposed regional
haze SIP with the New Mexico Environmental Improvement Board (EIB). The SIP proposes that the BART
for nitrogen oxides at San Juan is a technology known as “selective catalytic reduction” (SCR) plus
“sorbent injection.” PNM, the operator at San Juan, previously analyzed SCR and concluded it was not
the BART and intends to vigorously challenge the NMED’s proposal. PNM’s earlier 2007 analysis
estimated the cost of installation of SCR technology with sorbent injection at San Juan to be $790
million. TEP’s share would be approximately 19.8% based on its ownership percentage. These
technologies would also increase operating costs at the generating station.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">Following a hearing by the EIB and EIB approval, the approved SIP will be submitted to the EPA for
approval. Under a court ordered deadline, the EPA is required to have the state’s SIP approved and
in place by November 10, 2010. If the EPA approves the SIP, including the NMED’s BART
determination, the San Juan participants would have five years after the EPA’s final determination to
achieve compliance with such BART requirements. TEP cannot predict the ultimate outcome of this
matter.
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<b>
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<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>Environmental Reclamation at Remote Generating Stations</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">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 corresponding coal supply
agreement. At June 30, 2010, and at December 31, 2009, TEP recorded liabilities of $10 million
based on TEP’s estimated $17 million obligation at the expiration dates of the coal supply
agreements in 2011 through 2019.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">TEP’s PPFAC allows TEP to pass-through most fuel costs, including final reclamation costs, to
customers. Therefore, TEP classifies these costs as a regulatory asset. TEP will increase the
regulatory asset and the reclamation liability over the remaining life of the coal supply
agreements on an accrual basis, and will recover the regulatory asset through the PPFAC as final
mine reclamation costs are paid to the coal suppliers.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">Amounts recorded for final reclamation are subject to various assumptions, such as estimating the
costs of reclamation, when final reclamation will occur, and the credit-adjusted risk-free interest
rate to be used to discount future liabilities. As these assumptions change, TEP will
prospectively adjust the expense amounts for final reclamation over the remaining coal supply
agreement term. TEP does not believe that recognition of its final reclamation obligations will be
material to TEP in any single year because recognition occurs over the remaining terms of its coal
supply agreements.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>California Energy Market Issues</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In March 2010, TEP and the California Attorney General, California Public Utilities Commission and
various private entities (collectively California Parties) reached a settlement in principal of all
remaining claims against TEP related to TEP’s transactions in the Western energy markets including
the California Power Exchange and the California Independent System Operator during the California
energy crisis of 2000 and 2001. As a result of the settlement with the California Parties, TEP
recognized an additional liability of $4 million in March 2010, bringing TEP’s gross liability
related to these claims to $6 million. In April 2010, TEP and the California Parties entered into
a written settlement agreement that FERC approved in June 2010 and TEP paid the liability in July
2010. Also, in association with the California Parties settlement, in March 2010, TEP recorded a
receivable from SRP for approximately $1 million related to a long-term power sale agreement
between TEP and SRP. The net $3 million is shown on TEP’s income statement as contra revenue. In
addition, in March 2010, UNS Electric reached a related settlement with Arizona Public Service
Company (APS) and recorded Other Income of $3 million that has since been received in cash. The
settlements described above offset and had no impact on UniSource Energy’s consolidated results in
the first half of 2010.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>Tucson to Nogales Transmission Line</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">TEP and UNS Electric are parties to a project development agreement for the joint construction of
an approximately 60-mile transmission line from Tucson to Nogales, Arizona. UNS Electric’s
participation in this project was initiated in response to an order by the ACC to improve
reliability to UNS Electric’s retail customers in Nogales, Arizona.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In 2002, the ACC approved the location and construction of the proposed 345-kV line along a route
identified as the Western Corridor route subject to a number of conditions, including obtaining all
required permits from state and federal agencies. The U.S. Forest Service subsequently identified
a preference for a route identified as the Central Corridor route in the final Environmental Impact
Statement for the project. TEP is considering options for the project including potential new
routes. If a decision is made to pursue an alternative route, approvals will be needed from the
ACC, the Department of Energy, U.S. Forest Service, Bureau of Land Management, and the
International Boundary and Water Commission. As of June 30, 2010, TEP had capitalized $11 million
related to the project, including $2 million of land and land rights. If TEP does not receive the
required approvals or abandons the project, TEP believes cost recovery is probable for prudent and
reasonably incurred costs related to the project as a consequence of the ACC’s requirement for a
second transmission line serving the Nogales, Arizona area.
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<b>
</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt"><b>GUARANTEES</b>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">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:
</div>
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<table width="100%" border="0" cellpadding="0" cellspacing="0" style="font-size: 10pt; text-align: left">
<tr valign="top" style="font-size: 10pt; color: #000000; background: transparent">
<td width="4%" style="background: transparent"> </td>
<td width="3%" nowrap="nowrap" align="left"><b>•</b></td>
<td width="1%"> </td>
<td>UES’ guarantee of $100 million senior unsecured notes issued by UNS Gas and $100
million senior unsecured notes issued by UNS Electric;</td>
</tr>
</table>
</div>
<div style="margin-top: 10pt">
<table width="100%" border="0" cellpadding="0" cellspacing="0" style="font-size: 10pt; text-align: left">
<tr valign="top" style="font-size: 10pt; color: #000000; background: transparent">
<td width="4%" style="background: transparent"> </td>
<td width="3%" nowrap="nowrap" align="left"><b>•</b></td>
<td width="1%"> </td>
<td>UES’ guarantee of the $60 million UNS Gas/UNS Electric Revolver;</td>
</tr>
</table>
</div>
<div style="margin-top: 10pt">
<table width="100%" border="0" cellpadding="0" cellspacing="0" style="font-size: 10pt; text-align: left">
<tr valign="top" style="font-size: 10pt; color: #000000; background: transparent">
<td width="4%" style="background: transparent"> </td>
<td width="3%" nowrap="nowrap" align="left"><b>•</b></td>
<td width="1%"> </td>
<td>UniSource Energy’s guarantee of approximately $2 million in building lease payments for
UNS Gas; and</td>
</tr>
</table>
</div>
<div style="margin-top: 10pt">
<table width="100%" border="0" cellpadding="0" cellspacing="0" style="font-size: 10pt; text-align: left">
<tr valign="top" style="font-size: 10pt; color: #000000; background: transparent">
<td width="4%" style="background: transparent"> </td>
<td width="3%" nowrap="nowrap" align="left"><b>•</b></td>
<td width="1%"> </td>
<td>UniSource Energy’s guarantee of the $33 million of outstanding loans under the UED
Credit Agreement.</td>
</tr>
</table>
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">To the extent liabilities exist under these contracts, the liabilities are included in our
consolidated balance sheets.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">We believe that the likelihood UniSource Energy or UES would be required to perform or otherwise
incur any significant losses associated with any of these guarantees is remote.
</div>
<div align="left" style="font-size: 10pt; margin-top: 10pt">In March 2010, TEP purchased 100% of the equity interest in Sundt Unit 4. We have indemnified the
seller of Sundt Unit 4 from any sales, use, transfer or similar taxes or fees due relating to the
purchase. The terms of the indemnification do not include a limit on potential future payments;
however, we believe that the parties to the agreement have abided by all tax laws and we do not
have any additional tax obligations. We have not made any payments under the terms of this
indemnification to date.
</div>
<div align="left">
</div>
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