Fair Value Measurements

6 Months Ended

Jun. 30, 2011

NOTE 9. FAIR VALUE MEASUREMENTS

The following tables set forth, by level within the fair value hierarchy, UniSource Energy’s and TEP’s assets and liabilities that were accounted for at fair value on a recurring basis as of June 30, 2011 and December 31, 2010. These assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. There were no transfers between Levels 1, 2 or 3 for either reporting period.


	UniSource Energy
	June 30, 2011
	Quoted Prices
	In		Significant
	Active Markets		Other			Significant
	for Identical		Observable			Unobservable
	Assets		Inputs			Inputs
	(Level 1)		(Level 2)			(Level 3)			Total
	-Millions of Dollars-
Assets
Cash Equivalents ⁽¹⁾	$	30	$	—		$	—		$	30
Rabbi Trust Investments to support the Deferred Compensation and SERP Plans ⁽²⁾		—		18			—			18
Collateral Posted ⁽³⁾		—		1			—			1
Energy Contracts ⁽⁴⁾		—		1			13			14

Total Assets		30		20			13			63


Liabilities
Energy Contracts ⁽⁴⁾		—		(12	)		(22	)		(34	)
Interest Rate Swaps ⁽⁵⁾		—		(10	)		—			(10	)

Total Liabilities		—		(22	)		(22	)		(44	)

Net Total Assets and (Liabilities)	$	30	$	(2	)	$	(9	)	$	19


	UniSource Energy
	December 31, 2010
	Quoted Prices
	In		Significant
	Active Markets		Other			Significant
	for Identical		Observable			Unobservable
	Assets		Inputs			Inputs
	(Level 1)		(Level 2)			(Level 3)			Total
	-Millions of Dollars-
Assets
Cash Equivalents ⁽¹⁾	$	38	$	—		$	—		$	38
Rabbi Trust Investments to support the Deferred Compensation and SERP Plans ⁽²⁾		—		16			—			16
Collateral Posted ⁽³⁾		—		3			—			3
Energy Contracts ⁽⁴⁾		—		—			15			15

Total Assets		38		19			15			72


Liabilities
Energy Contracts ⁽⁴⁾		—		(19	)		(25	)		(44	)
Interest Rate Swaps ⁽⁵⁾		—		(10	)		—			(10	)

Total Liabilities		—		(29	)		(25	)		(54	)

Net Total Assets and (Liabilities)	$	38	$	(10	)	$	(10	)	$	18


	TEP
	June 30, 2011
	Quoted Prices
	In		Significant
	Active Markets		Other			Significant
	for Identical		Observable			Unobservable
	Assets		Inputs			Inputs
	(Level 1)		(Level 2)			(Level 3)			Total
	-Millions of Dollars-
Assets
Cash Equivalents ⁽¹⁾	$	9	$	—		$	—		$	9
Rabbi Trust Investments to support the Deferred Compensation and SERP Plans ⁽²⁾		—		18			—			18
Collateral Posted ⁽³⁾		—		1			—			1
Energy Contracts ⁽⁴⁾		—		—			4			4

Total Assets		9		19			4			32


Liabilities
Energy Contracts ⁽⁴⁾		—		(5	)		(3	)		(8	)
Interest Rate Swaps ⁽⁵⁾		—		(10	)		—			(10	)

Total Liabilities		—		(15	)		(3	)		(18	)

Net Total Assets and (Liabilities)	$	9	$	4		$	1		$	14


	TEP
	December 31, 2010
	Quoted Prices
	In		Significant
	Active Markets		Other			Significant
	for Identical		Observable			Unobservable
	Assets		Inputs			Inputs
	(Level 1)		(Level 2)			(Level 3)			Total
	-Millions of Dollars-
Assets
Cash Equivalents ⁽¹⁾	$	21	$	—		$	—		$	21
Rabbi Trust Investments to support the Deferred Compensation and SERP Plans ⁽²⁾		—		16			—			16
Energy Contracts ⁽⁴⁾		—		—			3			3

Total Assets		21		16			3			40


Liabilities
Energy Contracts ⁽⁴⁾		—		(7	)		(2	)		(9	)
Interest Rate Swaps ⁽⁵⁾		—		(10	)		—			(10	)

Total Liabilities		—		(17	)		(2	)		(19	)

Net Total Assets and (Liabilities)	$	21	$	(1	)	$	1		$	21


(1)		Cash Equivalents are based on observable market prices and include the fair value of commercial paper, money market funds and certificates of deposit. These amounts are included in Cash and Cash Equivalents and Investments and Other Property — Other in the UniSource Energy and TEP balance sheets.

(2)		Rabbi Trust Investments include amounts held in mutual and money market funds related to deferred compensation and SERP benefits. The valuation is based on quoted prices traded in active markets. These investments are included in Investments and Other Property — Other in the UniSource Energy and TEP balance sheets.

(3)		Collateral provided for energy contracts with counterparties to reduce credit risk exposure. Collateral posted is included in Current Assets — Other in the UniSource Energy and TEP balance sheets.

(4)		Energy Contracts include gas swap agreements (Level 2), forward power purchase and sales contracts (Level 3), and forward power purchase contracts indexed to gas (Level 3), entered into to reduce exposure to energy price risk. These contracts are included in Derivative Instruments in the UniSource Energy and TEP balance sheets. The valuation techniques are described below. See Note 14.

(5)		Interest Rate Swaps are valued based on the 6-month LIBOR index or the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap index. These interest rate swaps are included in Derivative Instruments in the UniSource Energy and TEP balance sheets.

Energy Contracts

TEP, UNS Gas and UNS Electric primarily apply the market approach for recurring fair value measurements. Where observable inputs are available for substantially the full term of the asset or liability — such as gas swap derivatives valued using New York Mercantile Exchange (NYMEX) pricing, adjusted for basis differences — the instrument is categorized in Level 2. Derivatives valued using an aggregate pricing service or published prices that represent a consensus reporting of multiple brokers are categorized in Level 3.

For both power and gas prices, TEP and UNS Electric obtain quotes from brokers, major market participants, exchanges or industry publications and rely on their 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. The broker providing quotes for power prices states that the market information provided is indicative only but is believed to be reflective of market conditions as of the time and date indicated. In addition, energy derivatives include contracts where published prices are not readily available. These include contracts for delivery periods during non-standard time blocks, contracts for delivery during only a few months of a given year when prices are quoted only for the annual average, or contracts for delivery at illiquid delivery points. In these cases, management assumptions used to value such contracts include the use of percentage multipliers to value non-standard time blocks, the application of historical price curve relationships to calendar year quotes, and the inclusion of adjustments for transmission and line losses to value contracts at illiquid delivery points. 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 market credit default swap data. We review these assumptions on a quarterly basis.

The fair value of TEP’s purchase power call option is estimated using an internal pricing model which includes assumptions about market risks such as liquidity, volatility, and contract valuation. This model also considers credit and non-performance risk. UniSource Energy’s and TEP’s assessments of the significance of a particular input to the fair value measurements requires judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels.

The following tables set forth a reconciliation of changes in the fair value of assets and liabilities classified as Level 3 in the fair value hierarchy:


	UniSource
	Energy			TEP
	Three Months Ended
	June 30, 2011
	Energy Contracts
	-Millions of Dollars-
Balance as of March 31, 2011	$	(11	)	$	1
Gains (Losses) Realized/Unrealized
Recorded to:
Net Regulatory Assets — Derivative Instruments		(1	)		—
Settlements		3			—

Balance as of June 30, 2011	$	(9	)	$	1

Total gains (losses) attributable to the change in unrealized gains or losses relating to assets/liabilities still held at the end of the period	$	(1	)	$	—


	UniSource
	Energy			TEP
	Six Months Ended
	June 30, 2011
	Energy Contracts
	-Millions of Dollars-
Balance as of December 31, 2010	$	(10	)	$	1
Gains (Losses) Realized/Unrealized
Recorded to:
Net Regulatory Assets — Derivative Instruments		(3	)		1
Other Comprehensive Income		(1	)		(1	)
Settlements		5			—

Balance as of June 30, 2011	$	(9	)	$	1

Total gains (losses) attributable to the change in unrealized gains or losses relating to assets/liabilities still held at the end of the period	$	(3	)	$	—


	UniSource Energy									TEP
				Three Months Ended
				June 30, 2010
	Energy			Equity						Energy
	Contracts			Investments			Total			Contracts
	-Millions of Dollars-
Balance as of March 31, 2010	$	(16	)	$	6		$	(10	)	$	(2	)
Gains (Losses) Realized/Unrealized
Recorded to:
Net Regulatory Assets — Derivative Instruments		1			—			1			4
Other Expense		—			(5	)		(5	)		—
Settlements		4			—			4			—

Balance as of June 30, 2010	$	(11	)	$	1		$	(10	)	$	2

Total gains (losses) attributable to the change in unrealized gains or losses relating to assets/liabilities still held at the end of the period	$	—		$	—		$	—		$	4


	UniSource Energy									TEP
				Six Months Ended
				June 30, 2010
	Energy			Equity						Energy
	Contracts			Investments			Total			Contracts
	-Millions of Dollars-
Balance as of December 31, 2009	$	(13	)	$	6		$	(7	)	$	(4	)
Gains (Losses) Realized/Unrealized
Recorded to:
Net Regulatory Assets — Derivative Instruments		(4	)		—			(4	)		7
Other Comprehensive Income		(1	)		—			(1	)		(1	)
Other Expense		—			(5	)		(5	)		—
Settlements		7			—			7			—

Balance as of June 30, 2010	$	(11	)	$	1		$	(10	)	$	2

Total gains (losses) attributable to the change in unrealized gains or losses relating to assets/liabilities still held at the end of the period	$	(4	)	$	—		$	(4	)	$	6

Financial Instruments Not Carried at Fair Value

The fair value of a financial instrument is the market price that would be received 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 assets and liabilities, including Current Maturities of Long-Term Debt, and amounts outstanding under our credit agreements, approximate their fair value due to the short-term nature of these instruments; with the exception of $50 million of UNS Gas Senior Unsecured Notes with a make-whole provision on a call premium that have a fair value of $50.3 million. These items have been excluded from the table below;

•

Investments in Lease Debt and Equity: TEP calculated the present value of remaining cash flows at the balance sheet date using current market rates for instruments with similar characteristics with respect to credit rating and time-to-maturity. We also incorporate the impact of counterparty credit risk using market credit default swap data; and

•

Long-Term Debt: UniSource Energy and TEP used quoted market prices, where available, or calculated the present value of remaining cash flows at the balance sheet date using current market rates for bonds with similar characteristics with respect to credit rating and time-to-maturity. TEP considers the principal amounts of variable rate debt outstanding to be reasonable estimates of their fair value. We also incorporate the impact of our own credit risk using a credit default swap rate when determining the fair value of long-term debt.

The use of different estimation methods and/or market assumptions may yield different estimated fair value amounts. The amount recorded in the balance sheet (carrying value) and the estimated fair values of our financial instruments included the following:


	June 30, 2011				December 31, 2010
	Carrying		Fair		Carrying		Fair
	Value		Value		Value		Value
	-Millions of Dollars-
Assets:
TEP Investments in Lease Debt and Equity	$	66	$	75	$	105	$	112
Liabilities:
Long-Term Debt
TEP		1,004		917		1,004		866
UniSource Energy		1,371		1,315		1,353		1,243

- Definition

This item represents the complete disclosure regarding the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments, assets, and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the Company is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risk is are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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