UNITED
        STATES
 SECURITIES
        AND
        EXCHANGE COMMISSION
 Washington,
        D.C.
        20549
 
 **FORM
        10-Q**
 (Mark
        One)
 [
        X
        ]  **QUARTERLY
        REPORT PURSUANT TO SECTION 13 OR 15(d) OF**
 **THE SECURITIES EXCHANGE ACT OF 1934**
 
 For
        the quarterly
        period ended March 31, 2006
 
 OR
 
 [  
         ]  **TRANSITION
        REPORT PURSUANT TO SECTION 13 OR 15(d) OF**
 **THE
        SECURITIES EXCHANGE ACT OF 1934**
 For
        the transition period from __________ to
        __________ .
 
 Commission
                File
                  Number
              Registrant;
                  State of Incorporation;
                Address;
                  and Telephone Number
              IRS
                EmployerIdentification
                  Number1-13739
              **UNISOURCE
                  ENERGY CORPORATION**
                (An
                  Arizona
                  Corporation)
                One
                  South
                  Church Avenue, Suite 100
                Tucson,
                  AZ
                  85701
                (520)
                  571-4000
              86-07867321-5924
              **TUCSON
                  ELECTRIC POWER COMPANY**
                (An
                  Arizona
                  Corporation)
                One
                  South
                  Church Avenue, Suite 100
                Tucson,
                  AZ
                  85701
                (520)
                  571-4000
              86-0062700
 
 Indicate
        by check
        mark whether each registrant (1) has filed all reports required to be filed
        by
        Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding
        12 months (or for such shorter period that the registrant was required to
        file
        such reports), and (2) has been subject to such filing requirements for the
        past
        90 days. Yes X No____
  Indicate
                    by check mark whether the
                    registrant is a large accelerated filer, an accelerated filer
                    or a
                    non-accelerated filer. See definition of “accelerated filer” and “large
                    accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
                    one):UniSource
                      Energy Corporation
                  Large
                      Accelerated Filer X
                  Accelerated
                      Filer__
                  Non-accelerated
                      filer__Tucson
                      Electric Power Company
                  Large
                      Accelerated Filer__
                  Accelerated
                      Filer__
                  Non-accelerated
                      filer X
  Indicate
                      by check mark whether the
                      registrant is a shell company (as defined in Rule 12b-2 of
                      the
                      Act).UniSource
                        Energy Corporation
                    Yes
                    No
                        XTucson
                        Electric Power Company
                    Yes
                    No
                        X
  At
          May 2, 2006,
          35,065,941 shares of UniSource Energy Corporation Common Stock, no par
          value
          (the only class of Common Stock), were outstanding.
  At
          May 2, 2006,
          32,139,435 shares of Tucson Electric Power Company’s common stock, no par value,
          were outstanding, all of which were held by UniSource Energy
          Corporation.










This
      combined Form
      10-Q is separately filed by UniSource Energy Corporation and Tucson Electric
      Power Company. Information contained in this document relating to Tucson
      Electric Power Company is filed by UniSource Energy Corporation and separately
      by Tucson Electric Power Company on its own behalf. Tucson Electric Power
      Company makes no representation as to information relating to UniSource Energy
      Corporation or its subsidiaries, except as it may relate to Tucson Electric
      Power Company.










**Table
      of
      Contents**




Definitions
            iv**--
PART
                I --**Reports
                of Independent Registered Public
                Accounting Firm
            1Item
                1. - Financial Statements
            3UniSource
                Energy
                CorporationComparative
                Condensed Consolidated Statements of
                Income (Loss)
            3Comparative
                Condensed Consolidated Statements
                of Cash Flows
            4Comparative
                Condensed Consolidated Balance
                Sheets
            5Condensed
                Consolidated Statement of Changes in
                Stockholders’ Equity
            7Tucson
                Electric Power
                CompanyComparative
                Condensed Consolidated
                Statements of Income (Loss)
            8Comparative
                Condensed Consolidated
                Statements of Cash Flows
            9Comparative
                Condensed Consolidated Balance
                Sheets
            10Condensed
                Consolidated Statement of
                Changes in Stockholder’s Equity
            12Notes
                to Condensed Consolidated Financial
                Statements
            13Note
                1.Nature
                of Operations and Basis of Accounting
                Presentation
            13Note
                2.Regulatory
                Matters
            13Note
                3.Discontinued
                Operations - Sale of Global
                Solar
            16Note
                4.Business
                Segments
            17Note
                5.Accounting
                for Derivative Instruments and Trading
                Activities
            18Note
                6.Commitments
                and Contingencies
            20Note
                7.TEP
                Wholesale Accounts Receivable and
                Allowances
            22Note
                8.UniSource
                Energy Earnings Per Share
                (EPS)
            22Note
                9.Employee
                Benefits Plans
            23Note
                10.Share-Based
                Compensation Plans
            24Note
                11.Income
                and Other Taxes
            25Note
                12.New
                Accounting Pronouncements
            26Note
                13.Supplemental
                Cash Flow Information
            27Note
                14.Review
                by Independent Registered Public Accounting
                Firm
            28Item
                2. - Management’s Discussion and Analysis of Financial Condition
                and Results of Operations
            29UniSource
                Energy
                Consolidated
            29Overview
                of Consolidated Business
            29Outlook
                and Strategies
            30Results
                of Operations
            30Contribution
                by Business
                Segment
            31Liquidity
                and Capital
                Resources
            32Tucson
                Electric Power Company
            35Results
                of Operations
            35Factors
                Affecting Results of
                Operations
            37Liquidity
                and Capital
                Resources
            42UNS
                Gas
            45Results
                of Operations
            45Factors
                Affecting Results of
                Operations
            46Liquidity
                and Capital
                Resources
            47UNS
                Electric
            48Results
                of Operations
            48Factors
                Affecting Results of
                Operations
            49Liquidity
                and Capital
                Resources
            49Other
            51Results
                of Operations
            51Critical
                Accounting
                Estimates
            52New
                Accounting Pronouncements
            58Safe
                Harbor for Forward-Looking
                Statements
            58




ii




Item
                3. - Quantitative and Qualitative Disclosures about
                Market
                Risk
            59Item
                4. - Controls and Procedures
            62**PART
                II - OTHER INFORMATION**Item
                1. - Legal Proceedings
            62Item
                1A - Risk Factors
            63Item
                5. - Other Information
            63Non-GAAP
                Measures
            63Ratio
                of Earnings to Fixed
                Charges
            66SEC
                Reports Available on UniSource Energy’s
                Website
            66Item
                6. - Exhibits
            66Signatures
            67Exhibit
                Index
            68




iii




**DEFINITIONS**





The
      abbreviations
      and acronyms used in the 2006 first quarter 10-Q are defined below:







1941
                  Mortgage
              TEP’s
                  Indenture, dated as of April 1, 1941, to JPMorgan Chase Bank, successor
                  trustee, as supplemented and amended, which was satisfied and discharged
                  on June 10, 2005.1941
                  Mortgage
                  Bonds
              Bonds
                  issued
                  under the 1941 Mortgage.1992
                  Mortgage
              TEP’s
                  Indenture of Mortgage and Deed of Trust, dated as of December 1,
                  1992, to
                  the Bank of New York, successor trustee, as
                  supplemented.1992
                  Mortgage
                  Bonds
              Bonds
                  issued
                  under the 1992 Mortgage.ACC
              Arizona
                  Corporation Commission.ACC
                  Holding
                  Company Order
              The
                  order
                  approved by the ACC in November 1997 allowing TEP to form a holding
                  company.AMT
              Alternative
                  Minimum Tax.Bcf
              Billion
                  cubic
                  feet.Btu
              British
                  thermal unit(s).Capacity
              The
                  ability
                  to produce power; the most power a unit can produce or the maximum
                  that
                  can be taken under a contract; measured in MWs.Citizens
              Citizens
                  Communications Company.Citizens
                  Settlement Agreement
              An
                  agreement
                  with the ACC Staff dated April 1, 2003, addressing rate case and
                  financing
                  issues in the acquisition by UniSource Energy of the Citizens’ Arizona gas
                  and electric assets.Common
                  Stock
              UniSource
                  Energy’s common stock, without par value.Company
                  or
                  UniSource Energy
              UniSource
                  Energy Corporation.Emission
                  Allowance(s)
              An
                  allowance
                  issued by the Environmental Protection Agency which permits emission
                  of
                  one ton of sulfur dioxide or one ton of nitrogen oxide. These allowances
                  can be bought and sold.Energy
              The
                  amount of
                  power produced over a given period of time; measured in
                  MWh.EPA
              The
                  Environmental Protection Agency.ESP
              Energy
                  Service Provider.FAS
                  71
              Statement
                  of
                  Financial Accounting Standards No. 71: Accounting for the Effects
                  of
                  Certain Types of Regulation.FAS
                  133
              Statement
                  of
                  Financial Accounting Standards No. 133: Accounting for Derivative
                  Instruments and Hedging Activities, as amended.FAS
                  143
              Statement
                  of
                  Financial Accounting Standards No. 143: Accounting for Asset Retirement
                  Obligations.FERC
              Federal
                  Energy Regulatory Commission.Four
                  Corners
              Four
                  Corners
                  Generating Station.Global
                  Solar
              Global
                  Solar
                  Energy, Inc., a company that develops and manufactures thin-film
                  photovoltaic cells. Millennium sold its interest in Global Solar
                  in March
                  2006.Haddington
              Haddington
                  Energy Partners II, LP, a limited partnership that funds energy-related
                  investments.Heating
                  Degree Days
              An
                  index used
                  to measure the impact of weather on energy usage calculated by
                  subtracting
                  the average of the high and low daily temperatures from
                  65.IPS
              Infinite
                  Power Solutions, Inc., a company that develops thin-film batteries.
                  Millennium owns 31.4% of IPS.IRS
              Internal
                  Revenue Service.ITC
              Investment
                  Tax Credit.kWh
              Kilowatt-hour(s).kV
              Kilovolt(s).LIBOR
              London
                  Interbank Offered Rate.Luna
              Luna
                  Energy
                  Facility.MEG
              Millennium
                  Environment Group, Inc., a wholly-owned subsidiary of Millennium,
                  which
                  manages and trades emission allowances
  iv
  and
                related financial instruments.MicroSat
              MicroSat
                  Systems, Inc. is a company formed to develop and commercialize
                  small-scale
                  satellites. Millennium sold its investment in MicroSat in January
                  2006.Millennium
              Millennium
                  Energy Holdings, Inc., a wholly-owned subsidiary of UniSource
                  Energy.MMBtus
              Million
                  British Thermal Units.MW
              Megawatt(s).MWh
              Megawatt-hour(s).Navajo
              Navajo
                  Generating Station.NOL
              Net
                  Operating
                  Loss carryback or carryforward for income tax purposes.PGA
              Purchased
                  Gas
                  Adjuster, a retail rate mechanism designed to recover the cost
                  of gas
                  purchased for retail gas customers.PNM
              Public
                  Service Company of New Mexico.PPFAC
              Purchased
                  Power and Fuel Adjustment Clause.PWCC
              Pinnacle
                  West
                  Capital Corporation.Rules
              Retail
                  Electric Competition Rules.Sabinas
              Carboelectrica
                  Sabinas, S. de R.L. de C.V., a Mexican limited liability company.
                  Millennium owns 50% of Sabinas.San
                  Carlos
              San
                  Carlos
                  Resources Inc., a wholly-owned subsidiary of TEP.San
                  Juan
              San
                  Juan
                  Generating Station.Settlement
                  Agreement
              TEP’s
                  Settlement Agreement approved by the ACC in November 1999 that
                  provided
                  for electric retail competition and transition asset
                  recovery.Springerville
              Springerville
                  Generating Station.Springerville
                  Coal Handling Facilities Leases
              Leveraged
                  lease arrangements relating to the coal handling facilities serving
                  Springerville.Springerville
                  Common Facilities
              Facilities
                  at
                  Springerville used in common with Springerville Unit 1 and Springerville
                  Unit 2.Springerville
                  Common Facilities Leases
              Leveraged
                  lease arrangements relating to an undivided one-half interest in
                  certain
                  Springerville Common Facilities.Springerville
                  Unit 1
              Unit
                  1 of the
                  Springerville Generating Station.Springerville
                  Unit 1 Lease
              Leveraged
                  lease arrangement relating to Springerville Unit 1 and an undivided
                  one-half interest in certain Springerville Common
                  Facilities.Springerville
                  Unit 2
              Unit
                  2 of the
                  Springerville Generating Station.Springerville
                  Unit 3
              Unit
                  3 of the
                  Springerville Generating Station.SRP
              Salt
                  River
                  Project Agricultural Improvement and Power District.Sundt
              H.
                  Wilson
                  Sundt Generating Station (formerly known as the Irvington Generating
                  Station).SWG
              Southwest
                  Gas
                  Corporation.TEP
              Tucson
                  Electric Power Company, the principal subsidiary of UniSource
                  Energy.TEP
                  Credit
                  Agreement
              Credit
                  Agreement between TEP and a syndicate of banks, dated as of May
                  4,
                  2005.TEP
                  Revolving
                  Credit Facility
              $60
                  million
                  revolving credit facility entered into under the TEP Credit Agreement,
                  dated as of May 4, 2005, between a syndicate of banks and
                  TEP.Therm
              A
                  unit of
                  heating value equivalent to 100,000 British thermal units
                  (Btu).Tri-State
              Tri-State
                  Generation and Transmission Association.UED
              UniSource
                  Energy Development Company, a wholly-owned subsidiary of UniSource
                  Energy,
                  which engages in developing generation resources and other project
                  development services and related activities.UES
              UniSource
                  Energy Services, Inc., an intermediate holding company established
                  to own
                  the operating companies (UNS Gas and UNS Electric) which acquired
                  the
                  Citizens Arizona gas and electric utility assets in
                  2003.UES
                  Settlement Agreement
              An
                  agreement
                  with the ACC Staff dated April 1, 2003, addressing rate case and
  v
  financing issues in the acquisition by UniSource Energy
                  of
                  Citizens’ Arizona gas
                andelectric
                  assets.UniSource
                  Credit Agreement
              Credit
                  Agreement between UniSource Energy and a syndicate of banks, dated
                  as of
                  April 15, 2005.UniSource
                  Energy
              UniSource
                  Energy Corporation.UNS
                  Electric
              UNS
                  Electric,
                  Inc., a wholly-owned subsidiary of UES, which acquired the Citizens
                  Arizona electric utility assets in 2003.UNS
                  Gas
              UNS
                  Gas,
                  Inc., a wholly-owned subsidiary of UES, which acquired the Citizens
                  Arizona gas utility assets in 2003.Valencia
              Valencia
                  power plant owned by UNS
                  Electric.





vi




**Reportof
      Independent Registered Public Accounting
      Firm**




To
      the Board of Directors and Stockholders of


UniSource
      Energy
      Corporation:





We
      have reviewed the accompanying condensed consolidated balance sheet of
      UniSource Energy Corporation and its subsidiaries (the
      Company)****as of March 31, 2006, and the related condensed
      consolidated statements of income (loss) and cash flows for the three-month
      periods ended March 31, 2006 and 2005 and the condensed consolidated statement
      of changes in stockholders’ equity and comprehensive income for the three-month
      period ended March 31, 2006. These interim financial statements are the
      responsibility of the Company’s management.





We
      conducted our review in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). A review of interim financial
      information consists principally of applying analytical procedures and making
      inquiries of persons responsible for financial and accounting matters. It is
      substantially less in scope than an audit conducted in accordance with the
      standards of the Public Company Accounting Oversight Board, the objective of
      which is the expression of an opinion regarding the financial statements taken
      as a whole. Accordingly, we do not express such an opinion.


Based
      on our
      review, we are not aware of any material modifications that should be made
      to
      the accompanying condensed consolidated interim financial statements for
      them **** to
      be in conformity
      with accounting principles generally
      accepted
      in the United States of America .





We
      have previously audited, in accordance with the standards of the Public Company
      Accounting Oversight Board (United States), the consolidated balance sheet
      as of
      December 31, 2005, and
      the related
      consolidated statements of income, of cash flows, of capitalization, of changes
      in stockholders’ equity and comprehensive income for the year then
      ended ,
      management’s assessment of the effectiveness of the Company’s internal control
      over financial reporting as of December 31, 2005 and the effectiveness of the
      Company’s internal control over financial reporting as of December 31, 2005; and
      in our report dated March 3, 2006, we expressed unqualified opinions thereon.
      The consolidated financial statements and management’s assessment of the
      effectiveness of internal control over financial reporting referred to above
      are
      not presented herein. In our opinion, the information set forth in the
      accompanying condensed consolidated balance sheet as of March 31, 2006, is
      fairly stated in all material respects in relation to the consolidated balance
      sheet from which it has been derived.






/s/
      PricewaterhouseCoopers LLP




**PricewaterhouseCoopers
      LLP**




Chicago,
      Illinois


May
      3,
      2006




1




**Report
      of
      Independent Registered Public Accounting Firm**





To
      the Board of Directors and Stockholders of


Tucson
      Electric
      Power Company:





We
      have reviewed the accompanying condensed consolidated  balance sheet
      of Tucson Electric Power Company and its subsidiaries (the Company) as of March
      31,
      2006, and the related condensed consolidated statements of income (loss) and
      cash flows for each of the three-month periods ended March 31, 2006 and 2005 and
      the condensed consolidated statement of changes in stockholders’ equity and
      comprehensive income for the three-month period ended March 31, 2006. These
      interim financial statements are the responsibility of the Company’s
      management.





We
      conducted our review in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). A review of interim financial
      information consists principally of applying analytical procedures and making
      inquiries of persons responsible for financial and accounting matters. It is
      substantially less in scope than an audit conducted in accordance with the
      standards of the Public Company Accounting Oversight Board, the objective of
      which is the expression of an opinion regarding the financial statements taken
      as a whole. Accordingly, we do not express such an opinion.




Based
      on our
      review, we are not aware of any material modifications that should be made
      to
      the accompanying condensed consolidated interim financial statements for
      them **** to
      be in conformity
      with accounting principles generally
      accepted
      in the United States of America .





We
      have previously audited, in accordance with the standards of the Public Company
      Accounting Oversight Board (United States), the consolidated balance sheet
      as of
      December 31, 2005, and
      the related
      consolidated statements of income, of cash flows, of capitalization, of changes
      in stockholders’ equity and comprehensive income for the year then
      ended ,
      management’s assessment of the effectiveness of the Company’s internal control
      over financial reporting as of December 31, 2005 and the effectiveness of the
      Company’s internal control over financial reporting as of December 31, 2005; and
      in our report dated March 3, 2006, we expressed unqualified opinions thereon.
      The consolidated financial statements and management’s assessment of the
      effectiveness of internal control over financial reporting referred to above
      are
      not presented herein. In our opinion, the information set forth in the
      accompanying condensed consolidated balance sheet as of March 31, 2006, is
      fairly stated in all material respects in relation to the consolidated balance
      sheet from which it has been derived.






/s/
      PricewaterhouseCoopers LLP




**PricewaterhouseCoopers
      LLP**




Chicago,
      Illinois


May
      3,
      2006




2




PART
                  I - FINANCIAL INFORMATION**ITEM1.
                  FINANCIAL STATEMENTS****UNISOURCEENERGY
                  CORPORATION****COMPARATIVECONDENSED
                  CONSOLIDATED STATEMENTS
                  OF INCOME (LOSS)**Three
                  Months
                  EndedMarch
                  31,**2006**
              
              **2005****(Unaudited)**-Thousands
                  of
                  Dollars-**Operating
                  Revenues**Electric
                  Retail Sales
              
              **$**
              **182,669**
              
              $
              171,590Electric
                  Wholesale Sales
              
              
              **56,663**
              
              
              39,180Gas
                  Revenue
              
              
              **62,815**
              
              
              46,549Other
                  Revenues
              
              
              **2,806**
              
              
              3,353**Total
                  Operating Revenues**
              
              
              **304,953**
              
              
              260,672**Operating
                  Expenses**Fuel
              
              
              **50,216**
              
              
              47,291Purchased
                  Energy
              
              
              **81,682**
              
              
              64,407Other
                  Operations and Maintenance
              
              
              **53,815**
              
              
              59,783Depreciation
                  and Amortization
              
              
              **30,757**
              
              
              34,068Amortization
                  of Transition Recovery Asset
              
              
              **11,842**
              
              
              9,487Taxes
                  Other
                  Than Income Taxes
              
              
              **12,553**
              
              
              13,387**Total
                  Operating Expenses**
              
              
              **240,865**
              
              
              228,423**Operating
                  Income**
              
              
              **64,088**
              
              
              32,249**Other
                  Income (Deductions)**Interest
                  Income
              
              
              **4,927**
              
              
              4,961Other
                  Income
              
              
              **1,635**
              
              
              2,261Other
                  Expense
              
              
              **(728**
              **)**
              
              (2,351
              )**Total
                  Other Income (Deductions)**
              
              
              **5,834**
              
              
              4,871**Interest
                  Expense**Long-Term
                  Debt
              
              
              **18,684**
              
              
              20,352Interest
                  on
                  Capital Leases
              
              
              **18,547**
              
              
              19,746Other
                  Interest Expense
              
              
              **1,306**
              
              
              840Interest
                  Capitalized
              
              
              **(1,912**
              **)**
              
              (829
              )**Total
                  Interest Expense**
              
              
              **36,625**
              
              
              40,109**Income
                  (Loss) From Continuing Operations Before Income
                  Taxes**
              
              
              **33,297**
              
              
              (2,989
              )Income
                  Tax
                  Expense (Benefit)
              
              
              **13,806**
              
              
              (612
              )**Income
                  (Loss) From Continuing Operations**
              
              
              **19,491**
              
              
              (2,377
              )**Discontinued
                  Operations - Net of Tax**
              
              
              **(2,669**
              **)**
              
              (1,406
              )**Net
                  Income (Loss)**
              
              **$**
              **16,822**
              
              $
              (3,783
              )**Weighted-average
                  Shares of Common Stock Outstanding (000)**
              
              
              **35,116**
              
              
              34,583**Basic
                  Earnings (Loss) per Share****Continuing
                  Operations**
              
              **$**
              **0.56**
              
              $
              (0.07
              )**Discontinued
                  Operations**
              
              **$**
              **(0.08**
              **)**
              $
              (0.04
              )**Net
                  Income (Loss)**
              
              **$**
              **0.48**
              
              $
              (0.11
              )**Diluted
                  Earnings (Loss) per Share****Continuing
                  Operations**
              
              **$**
              **0.52**
              
              $
              (0.07
              )**Discontinued
                  Operations**
              
              **$**
              **(0.07**
              **)**
              $
              (0.04
              )**Net
                  Income (Loss)**
              
              **$**
              **0.45**
              
              $
              (0.11
              )**Dividends
                  Declared per Share**
              
              **$**
              **0.21**
              
              $
              0.19See
                  Notes to
                  Condensed Consolidated Financial Statements.
  3
  **UNISOURCE
                    ENERGY CORPORATION****COMPARATIVECONDENSED
                    CONSOLIDATED
                    STATEMENTS OF CASH FLOWS**Three
                    Months
                    EndedMarch
                    31,**2006**
                
                **2005****(Unaudited)**-Thousands
                    of
                    Dollars-**Cash
                    Flows from Operating Activities**Cash
                    Receipts
                    from Electric Retail Sales
                
                **$**
                **211,011**
                
                $
                206,194Cash
                    Receipts
                    from Electric Wholesale Sales
                
                
                **78,805**
                
                
                52,111Cash
                    Receipts
                    from Gas Sales
                
                
                **66,344**
                
                
                55,568MEG
                    Cash
                    Receipts from Trading Activity
                
                
                **203**
                
                
                38,566Interest
                    Received
                
                
                **10,509**
                
                
                10,488Performance
                    Deposits
                
                
                **3,323**
                
                
                6,349Sale
                    of
                    Excess Emission Allowances
                
                
                **1,645**
                
                
                1,569Income
                    Tax
                    Refunds Received
                
                
                **-**
                
                
                928Other
                    Cash
                    Receipts
                
                
                **1,358**
                
                
                1,994Fuel
                    Costs
                    Paid
                
                
                **(51,657**
                **)**
                
                (48,503
                )Purchased
                    Energy Costs Paid
                
                
                **(109,932**
                **)**
                
                (82,143
                )Wages
                    Paid,
                    Net of Amounts Capitalized
                
                
                **(27,978**
                **)**
                
                (27,989
                )Payment
                    of
                    Other Operations and Maintenance Costs
                
                
                **(32,559**
                **)**
                
                (39,624
                )MEG
                    Cash
                    Payments for Trading Activity
                
                
                **(812**
                **)**
                
                (39,044
                )Capital
                    Lease
                    Interest Paid
                
                
                **(36,617**
                **)**
                
                (38,387
                )Taxes
                    Paid,
                    Net of Amounts Capitalized
                
                
                **(23,564**
                **)**
                
                (22,663
                )Interest
                    Paid, Net of Amounts Capitalized
                
                
                **(24,425**
                **)**
                
                (29,142
                )Income
                    Taxes
                    Paid
                
                
                **(9,516**
                **)**
                
                (3,500
                )Net
                    Cash Used
                    by Operating Activities of Discontinued Operations
                
                
                **(2,710**
                **)**
                
                (1,894
                )Other
                    Cash
                    Payments
                
                
                **(1,159**
                **)**
                
                (939
                )**Net
                    Cash Flows – Operating Activities**
                
                
                **52,269**
                
                
                39,939**Cash
                    Flows from Investing Activities**Capital
                    Expenditures
                
                
                **(62,825**
                **)**
                
                (44,744
                )Proceeds
                    from
                    Investment in Springerville Lease Debt
                
                
                **10,028**
                
                
                8,251Other
                    Cash
                    Receipts
                
                
                **2,202**
                
                
                5,616Investment
                    in
                    and Loans to Equity Investees
                
                
                **(765**
                **)**
                
                (216
                )Net
                    Cash Used
                    by Investing Activities of Discontinued Operations
                
                
                **(46**
                **)**
                
                (15
                )**Net
                    Cash Flows - Investing Activities**
                
                
                **(51,406**
                **)**
                
                (31,108
                )**Cash
                    Flows from Financing Activities**Proceeds
                    from
                    Issuance of Long-Term Debt
                
                
                **-**
                
                
                150,000Repayments
                    of
                    Long-Term Debt
                
                
                **(1,250**
                **)**
                
                (53,150
                )Payments
                    on
                    Capital Lease Obligations
                
                
                **(50,272**
                **)**
                
                (48,377
                )Proceeds
                    from
                    Borrowings under Revolving Credit Facilities
                
                
                **72,000**
                
                
                -Payments
                    on
                    Borrowings under Revolving Credit Facilities
                
                
                **(40,000**
                **)**
                
                -Proceeds
                    from
                    Stock Options Exercised
                
                
                **2,060**
                
                
                4,116Other
                    Cash
                    Receipts
                
                
                **3,753**
                
                
                2,036Payment
                    of
                    Debt Issue/Retirement Costs
                
                
                **-**
                
                
                (5,126
                )Common
                    Stock
                    Dividends Paid
                
                
                **(7,338**
                **)**
                
                (6,537
                )Other
                    Cash
                    Payments
                
                
                **(1,245**
                **)**
                
                (1,567
                )**Net
                    Cash Flows - Financing Activities**
                
                
                **(22,292**
                **)**
                
                41,395Net
                    (Decrease) Increase in Cash and Cash Equivalents
                
                
                **(21,429**
                **)**
                
                50,226Cash
                    and Cash
                    Equivalents, Beginning of Year
                
                
                **144,679**
                
                
                154,028**Cash
                    and Cash Equivalents, End of Period**
                
                **$**
                **123,250**
                
                $
                204,254See
                    Note 13
                    for supplemental cash flow information.See
                    Notes to
                    Condensed Consolidated Financial Statements.
  4
  **UNISOURCE
                  ENERGY CORPORATION****COMPARATIVECONDENSED
                  CONSOLIDATED BALANCE SHEETS**March
                  31,
              
              
              December
                  31,**2006**
              
              
              **2005****(Unaudited)**-
                  Thousands of Dollars -**ASSETS****Utility
                  Plant**Plant
                  in
                  Service
              
              **$**
              **3,196,749**
              
              $
              3,167,900Utility
                  Plant
                  under Capital Leases
              
              
              **725,043**
              
              
              723,900Construction
                  Work in Progress
              
              
              **181,343**
              
              
              160,186**Total
                  Utility Plant**
              
              
              **4,103,135**
              
              
              4,051,986Less
                  Accumulated Depreciation and Amortization
              
              
              **(1,429,623**
              **)**
              
              (1,408,158
              )Less
                  Accumulated Amortization of Capital Lease Assets
              
              
              **(479,400**
              **)**
              
              (472,367
              )**Total
                  Utility Plant - Net**
              
              
              **2,194,112**
              
              
              2,171,461**Investments
                  and Other Property**Investments
                  in Lease Debt and Equity
              
              
              **146,037**
              
              
              156,301Noncurrent
                  Assets of Subsidiary Held for Sale
              
              
              **-**
              
              
              13,065Other
              
              
              **54,393**
              
              
              55,694**Total
                  Investments and Other Property**
              
              
              **200,430**
              
              
              225,060**Current
                  Assets**Cash
                  and Cash
                  Equivalents
              
              
              **123,250**
              
              
              144,679Trade
                  Accounts Receivable
              
              
              **98,644**
              
              
              99,338Unbilled
                  Accounts Receivable
              
              
              **45,928**
              
              
              53,920Receivable
                  for Sale of Subsidiary
              
              
              **16,000**
              
              
              -Allowance
                  for
                  Doubtful Accounts
              
              
              **(15,065**
              **)**
              
              (15,037
              )Materials
                  and
                  Fuel Inventory
              
              
              **66,489**
              
              
              65,716Trading
                  Assets
              
              
              **14,536**
              
              
              36,418Current
                  Regulatory Assets
              
              
              **11,181**
              
              
              15,563Deferred
                  Income Taxes - Current
              
              
              **7,036**
              
              
              9,104Interest
                  Receivable - Current
              
              
              **4,459**
              
              
              9,830Current
                  Assets of Subsidiary Held for Sale
              
              
              **-**
              
              
              5,100Other
              
              
              **21,164**
              
              
              19,883**Total
                  Current Assets**
              
              
              **393,622**
              
              
              444,514**Regulatory
                  and Other Assets**Transition
                  Recovery Asset
              
              
              **155,769**
              
              
              167,611Income
                  Taxes
                  Recoverable Through Future Revenues
              
              
              **38,839**
              
              
              39,936Other
                  Regulatory Assets
              
              
              **20,588**
              
              
              20,944Other
                  Assets
              
              
              **50,567**
              
              
              57,254**Total
                  Regulatory and Other Assets**
              
              
              **265,763**
              
              
              285,745**Total
                  Assets**
              
              **$**
              **3,053,927**
              
              $
              3,126,780See
                  Notes to
                  Condensed Consolidated Financial Statements.**(Continued)**
  5
  **UNISOURCE
                    ENERGY CORPORATION****COMPARATIVE
                    CONDENSED CONSOLIDATED BALANCE SHEETS**March
                    31,
                
                
                
                December
                    31,**2006**
                
                
                
                **2005****(Unaudited)****CAPITALIZATION
                    AND OTHER LIABILITIES**
                
                -
                    Thousands
                    of Dollars -**Capitalization**Common
                    Stock
                
                **$**
                **691,858**
                
                
                
                
                $
                689,185Accumulated
                    Deficit
                
                
                **(56,376**
                **)**
                
                
                
                
                (65,861
                )Accumulated
                    Other
                    Comprehensive Loss
                
                
                **(9,715**
                **)**
                
                
                
                
                (6,583
                )Common
                    Stock
                    Equity
                
                
                **625,767**
                
                
                
                
                
                616,741Capital
                    Lease
                    Obligations
                
                
                **615,177**
                
                
                
                
                
                665,737Long-Term
                    Debt
                
                
                **1,211,170**
                
                
                
                
                
                1,212,420**Total
                    Capitalization**
                
                
                **2,452,114**
                
                
                
                
                
                2,494,898**Current
                    Liabilities**Current
                    Obligations under
                    Capital Leases
                
                
                **55,409**
                
                
                
                
                
                48,804Borrowing
                    Under Revolving
                    Credit Facilities
                
                
                **37,000**
                
                
                
                
                
                5,000Current
                    Maturities of
                    Long-Term Debt
                
                
                **5,000**
                
                
                
                
                
                5,000Accounts
                    Payable
                
                
                **71,384**
                
                
                
                
                
                98,085Interest
                    Accrued
                
                
                **26,189**
                
                
                
                
                
                57,386Trading
                    Liabilities
                
                
                **7,408**
                
                
                
                
                
                27,300Taxes
                    Accrued
                
                
                **51,513**
                
                
                
                
                
                64,804Accrued
                    Employee
                    Expenses
                
                
                **14,038**
                
                
                
                
                
                16,052Customer
                    Deposits
                
                
                **15,773**
                
                
                
                
                
                15,463Current
                    Liabilities of
                    Subsidiary Held for Sale
                
                
                **-**
                
                
                
                
                
                2,206Other
                
                
                **4,740**
                
                
                
                
                
                3,933**Total
                    Current Liabilities**
                
                
                **288,454**
                
                
                
                
                
                344,033**Deferred
                    Credits and Other Liabilities**Deferred
                    Income Taxes -
                    Noncurrent
                
                
                **117,508**
                
                
                
                
                
                106,820Regulatory
                    Liability - Net
                    Cost of Removal for Interim Retirements
                
                
                **80,490**
                
                
                
                
                
                78,535Noncurrent
                    Liabilities of
                    Subsidiary Held for Sale
                
                
                **-**
                
                
                
                
                
                (11,539
                )Other
                
                
                **115,361**
                
                
                
                
                
                114,033**Total
                    Deferred Credits and Other Liabilities**
                
                
                **313,359**
                
                
                
                
                
                287,849**Commitments
                    and Contingencies (Note 6)****Total
                    Capitalization and Other Liabilities**
                
                **$**
                **3,053,927**
                
                
                
                
                $
                3,126,780See
                    Notes to
                    Condensed Consolidated Financial Statements.**(Concluded)**
 
 6
 **UNISOURCE
                    ENERGY CORPORATION****CONDENSEDCONSOLIDATED
                    STATEMENT OF CHANGES
                    IN STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME**AccumulatedCommon
                
                
                
                
                
                
                
                
                Other
                
                
                TotalShares
                
                
                Common
                
                
                Accumulated
                
                
                Comprehensive
                
                
                Stockholders'Issued*
                
                
                Stock
                
                
                Deficit
                
                
                Loss
                
                
                Equity**(Unaudited)**-
                    Thousands of
                    Dollars
                    -**Balances
                    at December 31, 2005**
                
                
                34,874
                
                $
                689,185
                
                $
                (65,861
                )
                $
                (6,583
                )
                $
                616,741Comprehensive
                    Income (Loss):2006
                    Year-to-Date Net Income
                
                
                -
                
                
                -
                
                
                16,822
                
                
                -
                
                
                16,822Unrealized
                    Loss on Cash Flow Hedges(net
                    of
                    $1,896 income taxes)
                
                
                -
                
                
                -
                
                
                -
                
                
                (2,892
                )
                
                (2,892
                )Reclassification
                    of Unrealized Gain onCash
                    Flow
                    Hedges to Net Income(net
                    of $149
                    income taxes)
                
                
                -
                
                
                -
                
                
                -
                
                
                (240
                )
                
                (240
                )Total
                    Comprehensive Income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                13,690Dividends
                    Declared
                
                
                -
                
                
                -
                
                
                (7,337
                )
                
                -
                
                
                (7,337
                )Shares
                    Issued
                    under Stock Compensation Plans
                
                
                11
                
                
                -
                
                
                -
                
                
                -
                
                
                -Shares
                    Issued
                    for Stock Options
                
                
                134
                
                
                2,060
                
                
                -
                
                
                -
                
                
                2,060Tax
                    Benefit
                    Realized from Stock Options Exercised
                
                
                -
                
                
                556
                
                
                
                
                
                
                
                
                556Other
                
                
                -
                
                
                57
                
                
                -
                
                
                -
                
                
                57**Balances
                    at March 31, 2006**
                
                
                **35,019**
                
                **$**
                **691,858**
                
                **$**
                **(56,376**
                **)**
                **$**
                **(9,715**
                **)**
                **$**
                **625,767***
                    UniSource
                    Energy has 75 million authorized shares of common stock.See
                    Notes to
                    Condensed Consolidated Financial Statements.
  7




**TUCSONELECTRIC
                  POWER
                  COMPANY****COMPARATIVECONDENSED
                  CONSOLIDATED
                  STATEMENTS OF INCOME (LOSS)**Three
                  Months
                  EndedMarch
                  31,**2006**
              
              **2005****(Unaudited)**-Thousands
                  of
                  Dollars-**Operating
                  Revenues**Electric
                  Retail
                  Sales
              
              **$**
              **148,934**
              
              $
              140,206Electric
                  Wholesale
                  Sales
              
              
              **56,603**
              
              
              39,128Other
                  Revenues
              
              
              **2,805**
              
              
              2,572**Total
                  Operating Revenues**
              
              
              **208,342**
              
              
              181,906**Operating
                  Expenses**Fuel
              
              
              **50,216**
              
              
              47,291Purchased
                  Power
              
              
              **13,155**
              
              
              12,861Other
                  Operations and
                  Maintenance
              
              
              **42,170**
              
              
              47,977Depreciation
                  and
                  Amortization
              
              
              **26,501**
              
              
              30,020Amortization
                  of Transition
                  Recovery Asset
              
              
              **11,842**
              
              
              9,487Taxes
                  Other Than Income
                  Taxes
              
              
              **10,487**
              
              
              11,149**Total
                  Operating Expenses**
              
              
              **154,371**
              
              
              158,785**Operating
                  Income**
              
              
              **53,971**
              
              
              23,121**Other
                  Income (Deductions)**Interest
                  Income
              
              
              **4,289**
              
              
              4,816Interest
                  Income - Note
                  Receivable from UniSource Energy
              
              
              **-**
              
              
              1,684Other
                  Income
              
              
              **1,065**
              
              
              1,765Other
                  Expense
              
              
              **(674**
              **)**
              
              (1,432
              )**Total
                  Other Income (Deductions)**
              
              
              **4,680**
              
              
              6,833**Interest
                  Expense**Long-Term
                  Debt
              
              
              **12,649**
              
              
              16,979Interest
                  on Capital
                  Leases
              
              
              **18,539**
              
              
              19,737Other
                  Interest
                  Expense
              
              
              **969**
              
              
              749Interest
                  Capitalized
              
              
              **(1,621**
              **)**
              
              (659
              )**Total
                  Interest Expense**
              
              
              **30,536**
              
              
              36,806**Income
                  (Loss) Before Income Taxes**
              
              
              **28,115**
              
              
              (6,852
              )Income
                  Tax Expense
                  (Benefit)
              
              
              **11,528**
              
              
              (2,162
              )**Net
                  Income (Loss)**
              
              **$**
              **16,587**
              
              $
              (4,690
              )See
                  Notes to
                  Condensed Consolidated Financial Statements.
  8
  **TUCSON
                    ELECTRIC POWER COMPANY****COMPARATIVECONDENSED
                    CONSOLIDATED
                    STATEMENTS OF CASH FLOWS**Three
                    Months
                    EndedMarch
                    31,**2006**
                
                2005**(Unaudited)**-Thousands
                    of
                    Dollars-**Cash
                    Flows from Operating Activities**Cash
                    Receipts from Electric
                    Retail Sales
                
                **$**
                **172,645**
                
                $
                168,807Cash
                    Receipts from Electric
                    Wholesale Sales
                
                
                **78,805**
                
                
                52,047Interest
                    Received
                
                
                **9,298**
                
                
                10,327Interest
                    Received --
                    UniSource
                
                
                **-**
                
                
                11,013Sale
                    of Excess Emission
                    Allowances
                
                
                **1,645**
                
                
                1,569Other
                    Cash
                    Receipts
                
                
                **916**
                
                
                1,090Income
                    Taxes Refunds
                    Received
                
                
                **-**
                
                
                713Fuel
                    Costs
                    Paid
                
                
                **(51,657**
                **)**
                
                (48,503
                )Purchased
                    Power Costs
                    Paid
                
                
                **(41,142**
                **)**
                
                (24,763
                )Wages
                    Paid, Net of Amounts
                    Capitalized
                
                
                **(22,733**
                **)**
                
                (22,949
                )Payment
                    of Other Operations
                    and Maintenance Costs
                
                
                **(27,632**
                **)**
                
                (34,665
                )Capital
                    Lease Interest
                    Paid
                
                
                **(36,609**
                **)**
                
                (38,378
                )Taxes
                    Paid, Net of Amounts
                    Capitalized
                
                
                **(14,765**
                **)**
                
                (14,325
                )Interest
                    Paid, Net of
                    Amounts Capitalized
                
                
                **(14,169**
                **)**
                
                (24,059
                )Income
                    Taxes
                    Paid
                
                
                **(10,675**
                **)**
                
                -Other
                    Cash
                    Payments
                
                
                **(767**
                **)**
                
                (766
                )**Net
                    Cash Flows – Operating Activities**
                
                
                **43,160**
                
                
                37,158**Cash
                    Flows from Investing Activities**Capital
                    Expenditures
                
                
                **(46,585**
                **)**
                
                (33,400
                )Proceeds
                    from Investment in
                    Springerville Lease Debt and Equity
                
                
                **10,028**
                
                
                8,251Other
                    Cash
                    Receipts
                
                
                -
                
                
                5,000**Net
                    Cash Flows - Investing Activities**
                
                
                **(36,557**
                **)**
                
                (20,149
                )**Cash
                    Flows from Financing Activities**Proceeds
                    from Repayment of
                    UniSource Energy Note
                
                
                **-**
                
                
                95,393Repayments
                    of Long-Term
                    Debt
                
                
                **-**
                
                
                (53,150
                )Payments
                    on Capital Lease
                    Obligations
                
                
                **(50,251**
                **)**
                
                (48,357
                )Proceeds
                    from Borrowings
                    under Revolving Credit Facility
                
                
                **60,000**
                
                
                -Payments
                    on Borrowings
                    under Revolving Credit Facility
                
                
                **(35,000**
                **)**
                
                -Other
                    Cash
                    Receipts
                
                
                **4,774**
                
                
                1,533Payment
                    of Debt
                    Issue/Retirement Costs
                
                
                **-**
                
                
                (355
                )Other
                    Cash
                    Payments
                
                
                **(240**
                **)**
                
                (5,688
                )**Net
                    Cash Flows - Financing Activities**
                
                
                **(20,717**
                **)**
                
                (10,624
                )Net
                    (Decrease) Increase in Cash and Cash Equivalents
                
                
                **(14,114**
                **)**
                
                6,385Cash
                    and Cash
                    Equivalents, Beginning of Year
                
                
                **53,433**
                
                
                113,207**Cash
                    and Cash Equivalents, End of Period**
                
                **$**
                **39,319**
                
                $
                119,592See
                    Note 13
                    for supplemental cash flow information.See
                    Notes to
                    Condensed Consolidated Financial Statements.
  9
 **TUCSON
                    ELECTRIC POWER COMPANY****COMPARATIVECONDENSED
                    CONSOLIDATED BALANCE
                    SHEETS**March
                    31,
                
                
                
                December
                    31,**2006**
                
                
                
                **2005****(Unaudited)****ASSETS**
                
                -
                    Thousands of Dollars -**Utility
                    Plant**Plant
                    in Service
                
                **$**
                **2,876,261**
                
                
                
                
                $
                2,861,511Utility
                    Plant under Capital
                    Leases
                
                
                **724,337**
                
                
                
                
                
                723,195Construction
                    Work in
                    Progress
                
                
                **153,437**
                
                
                
                
                
                132,427**Total
                    Utility Plant**
                
                
                **3,754,035**
                
                
                
                
                
                3,717,133Less
                    Accumulated
                    Depreciation and Amortization
                
                
                **(1,396,060**
                **)**
                
                
                
                
                (1,378,362
                )Less
                    Accumulated
                    Amortization of Capital Lease Assets
                
                
                **(479,159**
                **)**
                
                
                
                
                (472,149
                )**Total
                    Utility Plant - Net**
                
                
                **1,878,816**
                
                
                
                
                
                1,866,622**Investments
                    and Other Property**Investments
                    in Lease Debt
                    and Equity
                
                
                **146,037**
                
                
                
                
                
                156,301Other
                
                
                **24,636**
                
                
                
                
                
                24,238**Total
                    Investments and Other Property**
                
                
                **170,673**
                
                
                
                
                
                180,539**Current
                    Assets**Cash
                    and Cash
                    Equivalents
                
                
                **39,319**
                
                
                
                
                
                53,433Trade
                    Accounts
                    Receivable
                
                
                **74,040**
                
                
                
                
                
                78,487Unbilled
                    Accounts
                    Receivable
                
                
                **24,369**
                
                
                
                
                
                29,658Allowance
                    for Doubtful
                    Accounts
                
                
                **(14,187**
                **)**
                
                
                
                
                (14,528
                )Intercompany
                    Accounts
                    Receivable
                
                
                **5,151**
                
                
                
                
                
                5,807Income
                    Tax
                    Receivable
                
                
                **6,886**
                
                
                
                
                
                -Materials
                    and Fuel
                    Inventory
                
                
                **58,870**
                
                
                
                
                
                57,815Current
                    Regulatory
                    Assets
                
                
                **9,869**
                
                
                
                
                
                9,663Deferred
                    Income Taxes -
                    Current
                
                
                **6,564**
                
                
                
                
                
                10,684Interest
                    Receivable -
                    Current
                
                
                **4,320**
                
                
                
                
                
                9,747Trading
                    Assets
                
                
                **6,671**
                
                
                
                
                
                12,338Other
                
                
                **12,533**
                
                
                
                
                
                12,407**Total
                    Current Assets**
                
                
                **234,405**
                
                
                
                
                
                265,511**Regulatory
                    and Other Assets**Transition
                    Recovery Asset
                
                
                **155,769**
                
                
                
                
                
                167,611Income
                    Taxes Recoverable
                    Through Future Revenues
                
                
                **38,839**
                
                
                
                
                
                39,936Other
                    Regulatory
                    Assets
                
                
                **20,213**
                
                
                
                
                
                20,634Other
                    Assets
                
                
                **34,561**
                
                
                
                
                
                34,582**Total
                    Regulatory and Other Assets**
                
                
                **249,382**
                
                
                
                
                
                262,763**Total
                    Assets**
                
                **$**
                **2,533,276**
                
                
                
                
                $
                2,575,435See
                    Notes to
                    Condensed Consolidated Financial Statements.**(Continued)**
  10
 **TUCSON
                    ELECTRIC POWER COMPANY****COMPARATIVE
                    CONDENSED CONSOLIDATED BALANCE SHEETS**March
                    31,
                
                
                
                December
                    31,**2006**
                
                
                
                **2005****(Unaudited)****CAPITALIZATION
                    AND OTHER LIABILITIES**
                
                -
                    Thousands of Dollars -**Capitalization**Common
                    Stock
                
                **$**
                **795,971**
                
                
                
                
                $
                795,971Capital
                    Stock
                    Expense
                
                
                **(6,357**
                **)**
                
                
                
                
                (6,357
                )Accumulated
                    Deficit
                
                
                **(207,798**
                **)**
                
                
                
                
                (224,385
                )Accumulated
                    Other
                    Comprehensive Loss
                
                
                **(9,715**
                **)**
                
                
                
                
                (6,583
                )Common
                    Stock
                    Equity
                
                
                **572,101**
                
                
                
                
                
                558,646Capital
                    Lease
                    Obligations
                
                
                **614,760**
                
                
                
                
                
                665,299Long-Term
                    Debt
                
                
                **821,170**
                
                
                
                
                
                821,170**Total
                    Capitalization**
                
                
                **2,008,031**
                
                
                
                
                
                2,045,115**Current
                    Liabilities**Current
                    Obligations under
                    Capital Leases
                
                
                **55,322**
                
                
                
                
                
                48,718Borrowing
                    Under Revolving
                    Credit Facility
                
                
                **25,000**
                
                
                
                
                
                -Accounts
                    Payable
                
                
                **45,062**
                
                
                
                
                
                62,974Intercompany
                    Accounts
                    Payable
                
                
                **9,700**
                
                
                
                
                
                9,362Income
                    Taxes
                    Payable
                
                
                **-**
                
                
                
                
                
                17,111Interest
                    Accrued
                
                
                **23,452**
                
                
                
                
                
                50,230Taxes
                    Accrued
                
                
                **36,466**
                
                
                
                
                
                27,260Accrued
                    Employee
                    Expenses
                
                
                **12,023**
                
                
                
                
                
                14,585Trading
                    Liabilities
                
                
                **2,165**
                
                
                
                
                
                2,923Other
                
                
                **11,411**
                
                
                
                
                
                10,687**Total
                    Current Liabilities**
                
                
                **220,601**
                
                
                
                
                
                243,850**Deferred
                    Credits and Other Liabilities**Deferred
                    Income Taxes -
                    Noncurrent
                
                
                **137,483**
                
                
                
                
                
                119,895Regulatory
                    Liability - Net
                    Cost of Removal for Interim Retirements
                
                
                **76,345**
                
                
                
                
                
                74,825Other
                
                
                **90,816**
                
                
                
                
                
                91,750**Total
                    Deferred Credits and Other Liabilities**
                
                
                **304,644**
                
                
                
                
                
                286,470**Commitments
                    and Contingencies (Note 6)****Total
                    Capitalization and Other Liabilities**
                
                **$**
                **2,533,276**
                
                
                
                
                $
                2,575,435See
                    Notes to
                    Condensed Consolidated Financial Statements.**(Concluded)**
  11
 **TUCSON
                    ELECTRIC POWER COMPANY****CONDENSEDCONSOLIDATED
                    STATEMENT OF
                    CHANGES IN STOCKHOLDERS' EQUITY AND COMPREHENSIVE
                    INCOME**AccumulatedCapital
                
                
                
                Other
                
                TotalCommon
                
                Stock
                
                Accumulated
                
                Comprehensive
                
                Stockholder'sStock
                
                Expense
                
                Deficit
                
                Loss
                
                Equity**(Unaudited)**-
                    Thousands of
                    Dollars -**Balances
                    at December 31, 2005**
                
                $
                795,971
                
                $
                (6,357
                )
                $
                (224,385
                )
                $
                (6,583
                )
                $
                558,646Comprehensive
                    Income:2006
                    Year-to-Date Net Income
                
                
                -
                
                
                -
                
                
                16,587
                
                
                -
                
                
                16,587Unrealized
                    Loss on Cash Flow Hedges(net
                    of
                    $1,896 income taxes)
                
                
                -
                
                
                -
                
                
                -
                
                
                (2,892
                )
                
                (2,892
                )Reclassification
                    of Unrealized Gain onCash
                    Flow
                    Hedges to Net Income(net
                    of $149
                    income taxes)
                
                
                -
                
                
                -
                
                
                -
                
                
                (240
                )
                
                (240
                )Total
                    Comprehensive Income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                13,455**Balances
                    at March 31, 2006**
                
                **$**
                **795,971**
                
                **$**
                **(6,357**
                **)**
                **$**
                **(207,798**
                **)**
                **$**
                **(9,715**
                **)**
                **$**
                **572,101**See
                    Notes to
                    Condensed Consolidated Financial Statements.
  12
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **NOTE1. 
NATURE
          OF OPERATIONS AND BASIS OF
          ACCOUNTING PRESENTATION**
 
 UniSourceEnergy
          Corporation (UniSource Energy) is an exempt
          holding company under the Public Utility Holding Company Act of 1935. UniSource
          Energy has no significant operations of its own, but owns the common stock
          of
          Tucson Electric Power Company (TEP), UniSource Energy Services, Inc. (UES),
          Millennium Energy Holdings, Inc. (Millennium) and UniSource Energy Development
          Company (UED).
 
 TEP,
          a regulated
          public utility incorporated in Arizona since 1963, is UniSource Energy’s largest
          operating subsidiary and represented approximately 83% of UniSource Energy’s
          assets as of March 31, 2006. TEP generates, transmits and distributes
          electricity. TEP serves 387,000 retail electric customers in a 1,155 square
          mile
          area in Southern Arizona. TEP also sells electricity to other utilities
          and
          power marketing entities primarily located in the western U.S.
 
 UES
          holds the
          common stock of UNS Gas, Inc. (UNS Gas) and UNS Electric, Inc. (UNS Electric).
          UES has no significant operations of its own. UNS Gas is a gas distribution
          company serving approximately 142,000 retail customers in Mohave, Yavapai,
          Coconino, and Navajo Counties in northern Arizona, as well as Santa Cruz
          County
          in southeast Arizona. UNS Electric is an electric transmission and distribution
          company serving approximately 91,000 retail customers in Mohave and Santa
          Cruz
          Counties.
 
 Millennium
          invests
          in unregulated businesses. On March 31, 2006, UniSource Energy completed
          the
          sale of all of the capital stock of Global Solar Energy, Inc. (Global Solar),
          Millennium’s largest holding. See Note 3. UED engages in developing generating
          resources and other project development activities, including facilitating
          the
          expansion of the Springerville Generating Station, but has no significant
          operations.
 
 We
          conduct our
          business in three primary business segments - TEP’s Electric Utility segment,
          UNS Gas, and UNS Electric.
 
 References
          to “we”
and “our” are to UniSource Energy and its subsidiaries, collectively.
 
 The
          accompanying
          quarterly financial statements of UniSource Energy and TEP are unaudited
          but
          reflect all normal recurring accruals and other adjustments which we believe
          are
          necessary for a fair presentation of the results for the interim periods
          presented. These financial statements are presented in accordance with
          the
          Securities and Exchange Commission’s (SEC) interim reporting requirements which
          do not include all the disclosures required by accounting principles generally
          accepted in the United States of America (GAAP) for audited annual financial
          statements. The year-end condensed balance sheet data was derived from
          audited
          financial statements, but does not include disclosures required by GAAP
          for
          audited annual financial statements. This quarterly report should be reviewed
          in
          conjunction with UniSource Energy and TEP’s 2005 Annual Report on Form
          10-K.
 
 Weather,
          among
          other factors, causes seasonal fluctuations in TEP, UNS Gas and UNS Electric’s
          sales; therefore, quarterly results are not indicative of annual operating
          results. UniSource Energy and TEP have made minor reclassifications to
          the prior
          year financial statements for comparative purposes. The sale of Global
          Solar is
          reflected as discontinued operations in UniSource Energy’s financial statements
          and prior periods have been restated to conform to the current presentation.
          See
          Note 3. These reclassifications had no effect on Net Income.
 
 **NOTE2. 
REGULATORY
          MATTERS**
 
 **REGULATORY
          ACCOUNTING**
 
 TEP,
          UNS Gas and
          UNS Electric generally use the same accounting policies and practices used
          by
          unregulated companies for financial reporting under GAAP. However, sometimes
          these principles, such as Statement of Financial Accounting Standards No.
          71, *Accounting
          for
          the Effects of Certain Types of Regulation* (FAS 71), require
          special accounting treatment for regulated companies to show the effect
          of
          regulation. For example, in setting TEP, UNS Gas and UNS Electric’s retail
          rates, the Arizona Corporation Commission (ACC) may not allow TEP, UNS
          Gas or
          UNS Electric to currently charge their customers to recover certain expenses,
          but instead may require that these expenses be charged to customers in
          the
          future. In this situation, FAS 71 requires that TEP, UNS Gas and UNS Electric
          defer these items and show them as regulatory assets on the balance sheet
          until
          TEP, UNS Gas and UNS Electric are allowed to charge their customers. TEP,
          UNS
          Gas and UNS Electric
  13
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  then
          amortize these
          items as expense to the income statement as these charges are recovered
          from
          customers. Similarly, certain revenue items may be deferred as regulatory
          liabilities, which are also eventually amortized to the income statement
          as
          rates to customers are reduced.
 
 The
          conditions a
          regulated company must satisfy to apply the accounting policies and practices
          of
          FAS 71 include:
 
 · an
          independent
          regulator sets rates;
 · the
          regulator sets
          the rates to recover specific costs of delivering service; and
 · the
          service
          territory lacks competitive pressures to reduce rates below the rates set
          by the
          regulator.
 
 **IMPLICATIONS
          OF DISCONTINUING APPLICATION OF FAS 71**
 
 **TEP**
 
 Upon
          approval
          by the ACC of a settlement agreement (Settlement Agreement) in November
          1999,
          TEP discontinued application of FAS 71 for its generation operations. TEP
          continues to apply FAS 71 to its cost-based rate regulated operations,
          which
          include the transmission and distribution portions of its business.
 TEP’s
          transmission and
          distribution regulatory assets, net of regulatory liabilities, totaled
          $148
          million at March 31, 2006 and $163 million at December 31, 2005. Regulatory
          assets of $30 million are not presently included in rate base and consequently
          are not earning a return on investment. These regulatory assets are being
          recovered through the cost of service or are authorized to be collected
          in
          future base rates.
  TEP
          regularly assesses whether it can continue to apply FAS 71 to its cost-based
          rate regulated operations. If TEP stopped applying FAS 71 to these operations,
          it would write off the related balances of its regulatory assets as an
          expense
          and its regulatory liabilities as income on its income statement. Based
          on the
          regulatory asset balances, net of regulatory liabilities, at March 31,
          2006, if
          TEP had stopped applying FAS 71 to its remaining cost-based rate regulated
          operations, it would have recorded an extraordinary after-tax loss of $90
          million. While regulatory orders and market conditions may affect cash
          flows,
          TEP’s cash flows would not be affected if it stopped applying FAS 71.
  **UNS
          Gas and UNS Electric**
  UNS
          Gas
          and UNS Electric’s regulatory liabilities exceeded their regulatory assets by $9
          million at March 31, 2006. At December 31, 2005, UNS Gas and UNS Electric
          regulatory liabilities exceeded their regulatory assets by $4 million.
          As of
          March 31, 2006, UNS Electric has $7 million of regulatory liabilities that
          are
          not included in rate base. If UNS Gas and UNS Electric stopped applying
          FAS 71
          to their regulated operations, they would write off the related balances
          of
          their regulatory assets as an expense and would write off their regulatory
          liabilities as income on their income statements. Based on the regulatory
          asset
          and liability balances, if UNS Gas and UNS Electric had stopped applying
          FAS 71
          to their regulated operations, they would have recorded an extraordinary
          after-tax gain of $6 million at March 31, 2006. UNS Gas and UNS Electric’s cash
          flows would not be affected if they stopped applying FAS 71.
 
 **RECENT
          REGULATORY ACTION**
 
 **TEP**
 
 **Settlement Agreement**
 
 Given
          recent court action, the ACC may revise its Rules and rate methodologies
          prior
          to January 2009. In an effort to resolve the uncertainty surrounding the
          methodology that will be applied to determine TEP's rates for generation
          service
          after December 31, 2008, TEP filed a motion with the ACC in May 2005 requesting
          that the ACC issue an order declaring its position regarding the rate treatment
          that will be afforded to TEP's generation assets after 2008.
 
 TEP
          believes that any actions by the ACC should not deny TEP the economic benefits
          of the Settlement Agreement, and accordingly analyzed how the Settlement
          Agreement can be modified so as to: (i) preserve the
  14
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  intent
          of the
          parties; (ii) avoid a significant increase in rates in 2009; (iii) mitigate
          a
          negative financial impact on TEP; and (iv) provide all interested parties
          with
          certainty in the near future about TEP’s post-2008 rate structure.
 
 Procedural
          orders issued by
          the ACC administrative law judge (ALJ) did not rule on TEP’s May 2005 motion,
          but suggested that TEP file a motion to reopen the record approving the
          Settlement Agreement.
  Motion
          to Amend
          the Settlement Agreement
 
 In
          September 2005,
          TEP filed a motion and supporting testimony with the ACC to amend the Settlement
          Agreement. In the motion, TEP proposed the following amendments to extend
          the
          benefits and protections set forth in the Settlement Agreement and provide
          additional price stability for TEP customers:
 
 (1)
                The
                    extension
                    of the existing rate freeze at TEP’s current average retail base rate of
                    8.3 cents per kWh through December 31, 2010;
 
 (2)
                The
                    retention
                    of the current CTC amortization
                    schedule;
 
 (3)
                The
                    agreement
                    of TEP not to seek base rate treatment for certain generating
                    assets in
                    order to minimize the rates TEP’s customers will eventually pay once the
                    rate freeze has expired; and
 
 (4)
                The
                    implementation of an energy cost adjustment mechanism to protect
                    TEP and
                    its customers from energy market volatility, to be effective
                    after
                    December 31, 2008. TEP proposes the establishment of an incremental
                    Energy
                    Cost Adjustment Clause (ECAC). A base amount of retail energy
                    consumption
                    would be served at the existing fixed retail rates and the rate
                    on the
                    incremental amount of retail energy would be capped at an annual
                    proxy set
                    at forward power prices.
 
 In
          October 2005, a
          number of participants in TEP’s rate proceedings, including the Staff of the
          ACC, filed responses to TEP’s motion. Those responses reflect differing
          interpretations of the Settlement Agreement which established TEP’s existing
          rate structure and generation service rates. Responses filed by ACC Staff
          and
          the Residential Utility Consumer Office disputed TEP’s assertion that the
          existing rate structure contemplates market-based rates for generation
          services
          after December 31, 2008.
 
 On
          January 30,
          2006, the ALJ issued a recommended opinion and order denying TEP’s motion to
          amend the Settlement Agreement and ordered TEP to file a rate case no later
          than
          September 30, 2007, using a test year no earlier than December 31,
          2006.
 
 **ACC
          Order
          to Review the Settlement Agreement**
 
 On
          April 12, 2006,
          during a special open meeting, the ACC considered TEP’s motion to amend the
          Settlement Agreement and the ALJ’s recommended opinion and order, and issued an
          order which finds:
 
 ·
                the
                    meaning
                    of the Settlement Agreement and its effect on how TEP’s rates for
                    generation services will be determined after December 31, 2008
                    is in
                    dispute;
 ·
                it
                    is in the
                    public interest to resolve, as soon as possible, the
                    dispute;
 ·
                a
                    hearing
                    should be held to consider the Settlement Agreement. The hearing
                    should
                    address the following issues, but not limited to: the viability
                    of the
                    Settlement Agreement in light of the ACC’s Track A and Track B proceedings
                    and the court decision which invalidated portions of the ACC’s rules on
                    retail competition and related market pricing; a discussion and
                    presentation of the evidence regarding whether TEP will be able
                    to charge
                    market-based or cost-of-service rates after 2008; TEP’s proposed
                    amendments to the Settlement Agreement; demand side management;
                    renewable
                    energy standards; and time of use
                    tariffs;
 ·
                the
                    proceeding should fully explore various means for resolving whether
                    the
                    Settlement Agreement should remain in full force and effect;
                    be unwound;
                    be amended; or be novated; and
 ·
                orders
                    a
                    procedural schedule to be established that should allow for an
                    expeditious
                    but complete review of these
                    matters.
 
 A
          procedural
          conference has been scheduled for May 18, 2006 to determine a process for
          reviewing the Settlement Agreement as ordered by the ACC. TEP does not
          know when
          a procedural order will be issued and cannot predict whether the ACC will
          adopt
          TEP’s proposed amendments to the Settlement Agreement.
  15
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  **UNS
          Gas**
  In
          August
          2005, UNS Gas filed a request with the ACC to approve an increase in the
          PGA
          surcharge from $0.03 per therm to $0.27 per therm to be effective October
          1,
          2005. An increase was necessary to allow for the recovery of the existing
          PGA
          bank balance and recover projected costs of gas during the winter season.
 
 In
          October
          2005, the ACC approved the following PGA surcharges:
 
 **Surcharge
                    Amount**
                  **Per
                    Therm**
                **Period
                    In Effect**$0.15
                November
                    2005
                    - February 2006$0.25
                March
                    2006 -
                    April 2006$0.30
                May
                    2006 -
                    June 2006$0.35
                July
                    2006 -
                    September 2006$0.25
                October
                    2006
                    - November 2006$0.20
                December
                    2006
                    - February 2007$0.25
                March
                    2007 -
                    April 2007
 
 Currently,
          this PGA surcharge is expected to allow UNS Gas to fully recover the PGA
          bank
          balance in a timely manner. However, if gas prices increase, the PGA bank
          balance may continue to grow despite this surcharge. Changes in the market
          price
          for gas, sales volumes and surcharge changes could significantly change
          the PGA
          bank balance in the future. At March 31, 2006, the PGA bank balance was
          $1
          million.
  **NOTE3.** **DISCONTINUED
          OPERATIONS - SALE OF GLOBAL SOLAR**
 
 On
          March 31, 2006,
          UniSource Energy sold all of the capital stock of Global Solar to a German
          producer of photovoltaic modules and a European financial investor. UniSourceEnergy
          received $16 million in cash as part of the transaction; a portion of the
          proceeds were used to satisfy $10 million of secured promissory notes held
          by a
          UniSource Energy subsidiary. In addition to the cash purchase price, UniSource
          Energy received a ten-year option to purchase between 5 and 10 percent
          of the
          common stock of Global Solar. The option is only exercisable after the
          seventh
          anniversary of the closing or upon the occurrence of certain events including
          a
          sale of all or substantially all of the assets of Global Solar, a merger,
          a
          change of control transaction, an initial public offering of Global Solar
          common
          stock or the payment by Global Solar of dividends in excess of specified
          amounts. No value was assigned to this repurchase option.
 
 For
          the three
          months ended March 31, 2006, the results of Global Solar are reported as
          discontinued operations. Prior periods have been restated to conform to
          the
          current period presentation. The following summarizes the amounts included
          in
          Discontinued Operations - Net of Tax for all periods presented:
 
 Three
                    Months
                    EndedMarch
                    31,**2006**
                
                **2005**-Millions
                    of
                    Dollars-Revenues
                    from
                    Discontinued Operations
                
                **$**
                **1**
                
                $
                -Loss
                    from
                    Discontinued Operations
                
                **$**
                **(4**
                **)**
                $
                (2
                )Loss
                    on Sale
                    of Discontinued Operations
                
                
                **(1**
                **)**
                
                -Loss
                    from
                    Discontinued Operations Before Income Taxes
                
                
                **(5**
                **)**
                
                (2
                )Income
                    Tax
                    Benefit
                
                
                **(2**
                **)**
                
                (1
                )Discontinued
                    Operations - Net of Tax
                
                **$**
                **(3**
                **)**
                $
                (1
                )
 
 The
          Loss from
          D iscontinued
          Operations for the three months ended March 31, 2006 includes a $1 million
          write-down of the net assets to fair value less cost to sell and $3 million
          of
          operating losses recognized during the period.
  16
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  **NOTE4. 
BUSINESS
          SEGMENTS**
 
 Based
          on the way we
          organize our operations and evaluate performance, we have three reportable
          segments:
 
 (1) TEP,
          a vertically
          integrated electric utility business, is UniSource Energy’s largest
          subsidiary.
 (2) UNS
          Gas is a
          regulated gas distribution utility business.
 (3) UNS
          Electric is a
          regulated electric distribution utility business.
 
 UniSource
          Energy,
          UES and Millennium are holding companies. UED and several other subsidiaries
          and
          equity investments, which are not considered reportable segments, are included
          in All Other. All Other also includes the results of operations of Global
          Solar.
          As discussed in Note 3, at March 31, 2006, ** all
          of the common
          stock of Global Solar was sold and for the three months ended March 31,
          2006,
          the results of operations of Global Solar are reported as discontinued
          operations. Prior period segment information has been restated to conform
          to the
          current period presentation.
 
 Significant
          reconciling adjustments consist of the elimination of inter-company activity
          and
          balances. Millennium subsidiaries recorded revenue from transactions with
          TEP of
          $3 million during each of the three months ended March 31, 2006 and March
          31,
          2005. TEP’s related expense is reported in Other Operations and Maintenance
          expense on its income statement. Millennium’s revenue and TEP’s related expense
          are eliminated in UniSource Energy consolidation. Other significant reconciling
          adjustments include the elimination of investments in subsidiaries held
          by
          UniSource Energy, the inter-company note between UniSource Energy and TEP
          repaid
          in March 2005, the related interest income and expense on the note and
          reclassifications of deferred tax assets and liabilities.
 
 We
          disclose
          selected financial data for our reportable segments in the following table:
 **Reportable
                      Segments****TEP**
                  
                  **UNS**
                    **Gas**
                  
                  **UNS
                      Electric**
                  
                  **All**
                    **Other**
                  
                  **Reconciling
                      Adjustments**
                  
                  **UniSource
                          Energy Consolidated****Income
                      Statement**
                  
                  -Millions
                      of
                      Dollars-**Three
                      months ended March 31, 2006:**Operating Revenues - External
                  
                  $
                  208
                  
                  $
                  63
                  
                  $
                  34
                  
                  $
                  -
                  
                  $
                  -
                  
                  **$**
                  **305**Operating Revenues - Intersegment
                  
                  
                  1
                  
                  
                  -
                  
                  
                  -
                  
                  
                  3
                  
                  
                  (4
                  )
                  
                  **-**Income (Loss) from Continuing
                    Operations Before Income Taxes
                  
                  
                  28
                  
                  
                  8
                  
                  
                  1
                  
                  
                  (4
                  )
                  
                  -
                  
                  
                  **33**Discontinued
                      Operations - Net of Tax
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (3
                  )
                  
                  -
                  
                  
                  **(3**
                  **)**Net
                      Income
                      (Loss)
                  
                  
                  17
                  
                  
                  5
                  
                  
                  1
                  
                  
                  (6
                  )
                  
                  -
                  
                  
                  **17****Three
                      months ended March 31, 2005:**Operating
                      Revenues - External
                  
                  $
                  181
                  
                  $
                  47
                  
                  $
                  32
                  
                  $
                  1
                  
                  $
                  -
                  
                  **$**
                  **261**Operating
                      Revenues - Intersegment
                  
                  
                  1
                  
                  
                  -
                  
                  
                  -
                  
                  
                  3
                  
                  
                  (4
                  )
                  
                  **-**Income
                      (Loss)
                      from Continuing
                    Operations Before Income Taxes
                  
                  
                  (7
                  )
                  
                  7
                  
                  
                  1
                  
                  
                  (4
                  )
                  
                  -
                  
                  
                  **(3**
                  **)**Discontinued
                      Operations - Net of Tax
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (1
                  )
                  
                  -
                  
                  
                  **(1**
                  **)**Net
                      Income
                      (Loss)
                  
                  
                  (5
                  )
                  
                  4
                  
                  
                  1
                  
                  
                  (4
                  )
                  
                  -
                  
                  
                  **(4**
                  **)****Balance
                      Sheet**Total
                      Assets,
                      March 31, 2006
                  
                  $
                  2,533
                  
                  $
                  236
                  
                  $
                  167
                  
                  $
                  1,008
                  
                  $
                  (890
                  )
                  **$**
                  **3,054**Total
                      Assets,
                      December 31, 2005
                  
                  
                  2,575
                  
                  
                  233
                  
                  
                  161
                  
                  
                  1,032
                  
                  
                  (874
                  )
                  
                  **3,127**
  17
 **NOTES
                TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  **NOTE5. 
ACCOUNTING
          FOR DERIVATIVE INSTRUMENTS AND TRADING
          ACTIVITIES**
 
 TEP
          enters into
          forward contracts to purchase or sell a specified amount of capacity or
          energy
          at a specified price over a given period of time, within established limits
          to
          take advantage of favorable market opportunities and reduce exposure to
          energy
          price risk resulting from generation and procurement of power. In general,
          TEP
          enters into forward power purchase contracts when market conditions provide
          the
          opportunity to purchase energy for its load at prices that are below the
          marginal cost of its supply resources or to supplement its own resources
          (e.g.,
          during plant outages and summer peaking periods). TEP enters into forward
          power
          sales contracts when it forecasts that it has excess supply and the market
          price
          of energy exceeds its marginal cost. In addition, TEP has a natural gas
          supply
          agreement under which it purchases all of its gas requirements at spot
          market
          prices from Southwest Gas Corporation (SWG). In an effort to minimize price
          risk
          on these purchases, TEP enters into price swap agreements under which TEP
          purchases gas at fixed prices and simultaneously sells gas at spot market
          prices.
 
 All
          of TEP’s
          forward power sale contracts and forward power purchase contracts meet
          the
          definition of a derivative. A portion of TEP’s forward power contracts are
          considered to be normal purchases and sales and, therefore, are not required
          to
          be marked to market. However, some of TEP’s forward power contracts and all of
          the gas swap agreements are considered to be derivatives, which are required
          to
          be marked to market each reporting period. Certain of these forward power
          contracts, as well as the gas swaps, are accounted for as cash flow hedges.
          Unrealized gains and losses resulting from the change in the fair value
          of
          derivatives that meet the criteria for cash flow hedge accounting are recorded
          in Other Comprehensive Income, a component of Common Stock Equity, rather
          than
          in current earnings. The unrealized gains and losses are reclassified into
          earnings when the related transactions settle or terminate. At March 31,
          2006,
          the settlement dates of contracts accounted for as cash flow hedges extended
          through the fourth quarter of 2008. The unrealized gains and losses that
          TEP
          reclassified into earnings from Other Comprehensive Income were less than
          $0.4
          million during the three months ended March 31, 2006 and less than $0.2
          million
          during the three months ended March 31, 2005.
 
 The
          change in fair
          value of forward power contracts considered trading contracts, which are
          not
          accounted for as cash flow hedges, is recorded in Net Income. There were
          no
          gains or losses recognized in Net Income related to hedge ineffectiveness
          because all cash flow hedges are considered to be effective.
  TEP
          manages the
          risk of counterparty default by performing financial credit reviews, setting
          limits, monitoring exposures, requiring collateral when needed, and using
          a
          standardized agreement which allows for the netting of current period exposures
          to and from a single counterparty.
 
 UNS
          Gas and UNS
          Electric do not currently have any contracts that are required to be marked
          to
          market. UNS Gas does have a natural gas supply and management agreement
          under
          which it purchases substantially all of its gas requirements at market
          prices
          from BP Energy Company (BP). However, the contract terms allow UNS Gas
          to lock
          in fixed prices on a portion of its gas purchases by entering into fixed
          price
          forward contracts with BP at various times during the year. This enables
          UNS Gas
          to provide more stable prices to its customers. These purchases are made
          up to
          three years in advance with the goal of locking in fixed prices on at least
          45%
          of the expected monthly gas consumption prior to entering into the month.
          These
          forward contracts, as well as the main gas supply contract, meet the definition
          of normal purchases and therefore are not required to be marked to market.
 
 MEG,
          a wholly-owned
          subsidiary of Millennium, enters into swap agreements, options and forward
          contracts relating to Emissions Allowances. MEG marks its trading contracts
          to
          market by recording unrealized gains and losses and adjusting the related
          assets
          and liabilities on a monthly basis to reflect the market prices at the
          end of
          the month.
 
 The
          market prices
          used to determine fair values for TEP and MEG’s derivative instruments are
          estimated based on various factors including broker quotes, exchange prices,
          over the counter prices and time value.
  18
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  The
          net unrealized
          gains and losses from TEP’s derivative activities were as follows:
 
 Three
                    Months
                    EndedMarch
                    31,**2006**
                
                **2005**-Millions
                    of
                    Dollars-Net
                    Unrealized Loss on Forward Power Sales - Trading Contracts
                
                **$**
                **-**
                
                $
                (1
                )Net
                    Unrealized Gain on Forward Power Purchases - Trading
                    Contracts
                
                
                **1**
                
                
                1Pre-Tax
                    Unrealized Gain on
                    Trading Contracts Recorded in Earnings
                
                **$**
                **1**
                
                $
                -Net
                    Unrealized Gain on Forward Power Sales - Cash Flow Hedges
                
                **$**
                **2**
                
                $
                -Net
                    Unrealized (Loss) Gain on Gas Price Swaps - Cash Flow
                    Hedges
                
                
                **(7**
                **)**
                
                6Pre-Tax
                    Unrealized (Loss)
                    Gain on Cash Flow Hedges
                
                **$**
                **(5**
                **)**
                $
                6After
                    Tax Unrealized (Loss)
                    Gain on Cash Flow Hedges Recorded in OCI
                
                **$**
                **(3**
                **)**
                $
                4
 
 For
          the three
          months ended March 31, 2006, MEG had a net loss from trading activities
          of less
          than $0.5 million and for the three months ended March 31, 2005, MEG had
          a net
          gain from trading activities of less than $0.3 million.
 
 The
          fair value of
          TEP and MEG’s derivative assets and liabilities were as
          follows:
 March
                    31,
                
                December
                    31,**2006**
                
                **2005****Trading
                    Contracts**
                
                **Cash
                    Flow Hedges**
                
                **Trading
                    Contracts**
                
                **Cash
                    Flow Hedges**-Millions
                    of
                    Dollars-TEP:Derivative
                    Assets -
                    Current
                
                **$**
                **2**
                
                **$**
                **5**
                
                $
                2
                
                $
                10Derivative
                    Liabilities -
                    Current
                
                
                **(1**
                **)**
                
                **(1**
                **)**
                
                (2
                )
                
                (1
                )Net
                    Current
                    Trading Assets
                
                **$**
                **1**
                
                **$**
                **4**
                
                $
                -
                
                $
                9Derivative
                    Assets -
                    Noncurrent
                
                **$**
                **-**
                
                **$**
                **4**
                
                $
                -
                
                $
                4Derivative
                    Liabilities -
                    Noncurrent
                
                
                **-**
                
                
                **-**
                
                
                -
                
                
                (1
                )Net
                    Noncurrent
                    Trading Assets
                
                **$**
                **-**
                
                **$**
                **4**
                
                $
                -
                
                $
                3
  March
                      31,
                    **2006**
                  
                  December
                      31,**2005**-Millions
                      of
                      Dollars-MEG:Trading
                      Assets - Current
                  
                  **$**
                  **8**
                  
                  $
                  24Trading
                      Liabilities -
                      Current
                  
                  
                  **(5**
                  **)**
                  
                  (24
                  )Net
                      Current
                      Trading Assets
                  
                  **$**
                  **3**
                  
                  $
                  -Trading
                      Assets - Noncurrent
                  
                  **$**
                  **8**
                  
                  $
                  14Trading
                      Liabilities -
                      Noncurrent
                  
                  
                  **-**
                  
                  
                  (1
                  )Net
                      Noncurrent
                      Trading Assets
                  
                  **$**
                  **8**
                  
                  $
                  13
 The
          settlement of
          forward power purchase and sales contracts that do not result in physical
          delivery are recorded net as a component of Electric Wholesale Sales in
          TEP’s
          income statement. For the three months ended March 31, 2006, approximately
          $16
          million in sales were netted against approximately $15 million in purchases.
          For
          the three months ended March 31, 2005, $5 million in sales were netted
          against
          $4 million in purchases.
  19
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  **NOTE6. 
COMMITMENTS
          AND CONTINGENCIES**
  **TEP
          COMMITMENTS**
 
 **Power
          Purchase from Springerville Unit 3**
 
 Tri-State
          Generation and Transmission Association, Inc. (Tri-State) will lease
          Springerville Unit 3, a 400 MW coal-fired generating facility at TEP’s existing
          Springerville Generating Station, from a financial owner through a 34-year
          leveraged lease arrangement. TEP executed contracts to provide operating,
          maintenance and other services to Unit 3. TEP also agreed to purchase up
          to 100
          MW of Tri-State system capacity for no more than five years from the time
          Unit 3
          begins commercial operation, which we expect to occur in the third quarter
          of
          2006. Tri-State may reduce the 100 MW available to TEP in 25 MW increments
          by
          submitting written notice to TEP at least 90 days in advance. To date,
          TEP has
          received no such notice and expects to begin taking the power in the third
          quarter.
 
 **TEP
          Guarantee Home Program**
 
 TEP
          provides
          incentives to new home builders to construct TEP Guarantee Homes that meet
          the
          highest construction and energy-efficiency standards available. TEP inspects
          these homes to ensure that specific energy-efficiency standards are met.
          TEP
          then guarantees the home's heating and cooling operating costs for five
          years.
          At March 31, 2006, TEP has commitments to pay various home builders $2
          million
          in builder incentives through 2007.
  **UNS
          ELECTRIC
          COMMITMENTS**
 
 In
          May 2006, UNS
          Electric entered into a 25 MW power supply agreement with Credit Suisse
          for the
          period June 2008 through December 2013.  The
          25 MW consists
          of 10 MW at fixed price with the remaining 15 MW price indexed to natural
          gas
          prices. UNS Electric’s minimum expected annual payment under this contract is $9
          million.
  **TEP
          CONTINGENCIES**
 
 **Springerville
          Common Facilities Leases**
 
 In
          1985, TEP sold
          and leased back its undivided one-half ownership interest in the common
          facilities at the Springerville Generating Station.  Under the terms of the
          Springerville Common Facilities Leases, TEP must arrange for refinancing or
          refunding of the secured notes underlying the leases prior to June 30,
          2006 to
          avoid a special event of loss. A special event of loss results in a termination
          of the leases and would require TEP to repurchase the facilities for
          approximately $125 million. TEP is currently in the process of amending
          agreements to refinance this debt.
 
 **Litigation
          and Claims Related to San Juan Generating Station**
 Public
            Service
            Company of New Mexico, operator of San Juan, and the coal supplier to
            San Juan
            have been participating in sessions sponsored by the Environmental Protection
            Agency (EPA) to consider rulemaking for the disposal of coal combustion
            products
            because of claims by third parties that San Juan has contaminated water
            resources in the region as a result of disposing of fly ash in the surface
            mine
            pits adjacent to the generating station. In November 2004, a contractor
            for the
            EPA released a non-binding preliminary determination that any contamination
            at
            San Juan cannot be conclusively attributed to the disposal of fly ash;
            however,
            the EPA has not made a final determination. TEP owns 50% of San Juan
            Units 1 and
            2, which equates to 19.8% of the total San Juan Generating Station. TEP
            does not
            believe that this issue will have an adverse impact on TEP or its
            operations.
 **Claims
              Related to San Juan Coal Company**
 
 San
              Juan Coal
              Company, 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. 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 San Juan Coal Company’s
              underground coal mining
  20
 **NOTES
                  TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  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. San Juan Coal
              Company 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. TEP cannot estimate
              the
              outcome of any future claims by these gas producers on the cost of
              coal at San Juan.
 **Litigation
            and
            Claims Related to Navajo Generating Station**
 
 On
          October 15,
          2004, Peabody Western Coal Company (Peabody), the coal supplier to the
          Navajo
          Generating Station, 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 and breach of the coal supply
          agreement. The case was removed to Federal District Court Eastern District
          of
          Missouri on February 10, 2005. Peabody subsequently filed a motion to remand
          to
          superior court. Because TEP owns 7.5% of the Navajo Generating Station,
          its
          share of the current claimed damages would be approximately $35 million.
          TEP
          believes these claims are without merit and intends to continue to contest
          them.
 **Postretirement
            and Pension Benefit Costs at Navajo Generating Station**
 
 In
            1996, Peabody
            filed a lawsuit in Maricopa County Superior Court against the participants
            at
            Navajo Generating Station, including TEP, for postretirement benefit
            costs
            payable to the coal supplier’s employees under the coal supply agreements. The
            Navajo participants and Peabody have agreed to stay the discovery process
            in
            this litigation to allow the parties additional time to negotiate a potential
            settlement . To
            the extent that
            amounts become estimable and payment probable, TEP will record a liability
            for
            additional postretirement benefit costs at the Navajo Generating Station.
            TEP
            believes any claim for postretirement benefits payable to the coal supplier's
            employees will be settled and included in the cost of coal at the time
            the coal
            supply agreement is extended; the current coal supply agreement expires
            in
            October 2010.
 
 TEP
            has previously
            settled claims for postretirement benefit costs with the coal suppliers
            at
            Springerville Generating Station and Four Corners Generating Station.
            The cost
            of postretirement benefits is included in the cost of coal to San
            Juan.
 **Environmental
          Reclamation at Remote Generating Stations**
 
 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 respective coal supply agreement. TEP estimates
          its undiscounted final reclamation liability to be $41 million, and the
          present
          value of TEP’s liability for final reclamation approximates $11 million at the
          expiration dates of the coal supply agreements. At March 31, 2006 and December
          31, 2005, TEP had recorded $2 million of its post-term reclamation liability,
          which is included in Other Liabilities in the balance sheets.
 
 Amounts
          recorded
          for final reclamation are subject to various assumptions and determinations,
          such as estimating the costs of reclamation, estimating when final reclamation
          will occur, and the credit-adjusted risk-free interest rate to be used
          to
          discount future liabilities. Changes that may arise over time with regard
          to
          these assumptions and determinations will change amounts recorded in the
          future
          as expense for post-term reclamation. TEP does not believe that recognition
          of
          its final reclamation obligations will be material to TEP in any single
          year
          since recognition occurs over the remaining lives of its coal supply
          agreements.
  **GUARANTEES
          AND
          INDEMNITIES**
 
 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:
 
 ·
                UES’
                    guarantee of $160 million of aggregate principal amount of senior
                    unsecured notes issued by UNS Gas and UNS Electric to purchase
                    the
                    Citizens Arizona gas and electric utility assets,
 ·
                UES’
                    guarantee of a $40 million unsecured revolving credit agreement
                    for UNS
                    Gas and UNS Electric, and
   21
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  ·
                UniSource
                    Energy’s guarantee of approximately $8 million in natural gas
                    transportation and supply payments in addition to building and
                    equipment
                    lease payments for UNS Gas, UNS Electric, and subsidiaries of
                    Millennium.
 
 To
          the extent
          liabilities exist under the contracts subject to these guarantees, such
          liabilities are included in UniSource Energy’s consolidated balance
          sheets.
 
 In
          addition,
          UniSource Energy and its subsidiaries have indemnified the purchasers of
          interests in certain investments from additional taxes due for years prior
          to
          the sale of such investments. The terms of the indemnifications provide
          for no
          limitation on potential future payments; however, we believe that we have
          abided
          by all tax laws and paid all tax obligations. We have not made any payments
          under the terms of these indemnifications to date.
 
 We
          believe that the
          likelihood UniSource Energy, UES, or Millennium would be required to perform
          or
          otherwise incur any significant losses associated with any of these guarantees
          or indemnities is remote.
 
 **NOTE7. 
TEP** **WHOLESALE
          ACCOUNTS RECEIVABLE AND ALLOWANCES**
 
 TEP’s
          Accounts
          Receivable from Electric Wholesale Sales, included in Trade Accounts Receivable
          on the balance sheet, totaled $29 million at March 31, 2006 and $30 million
          at
          December 31, 2005, net of allowances. TEP’s Allowance for Doubtful Accounts on
          the balance sheet includes $13 million at March 31, 2006 and December 31,
          2005
          related to sales to the California Power Exchange (CPX) and the California
          Independent System Operator (CISO) in 2001 and 2000.
 
 The
          FERC staff has
          proposed various methodologies for calculating amounts of refunds/offsets
          applicable to wholesale sales made into the CISO’s spot markets from October
          2000 to June 2001. In 2004, the FERC issued two separate orders addressing
          numerous issues in the refund calculation and the fuel cost allowance
          calculation (an offset to the refund obligation). Based on these orders,
          TEP has
          a reserve for sales to the CPX and the CISO of $3 million.
 
 There
          are several
          other outstanding legal issues, complaints and lawsuits concerning the
          California energy crisis related to the FERC, wholesale power suppliers,
          Southern California Edison Company, Pacific Gas and Electric Company, the
          CPX
          and the CISO. We cannot predict the outcome of these issues or lawsuits.
          We
          believe, however, that TEP is adequately reserved for its transactions
          with the
          CPX and the CISO.
 
 **NOTE8. 
UNISOURCE
          ENERGY EARNINGS PER SHARE
          (EPS)** ****
 
 Basic
          EPS is
          computed by dividing Net Income by the weighted average number of common
          shares
          outstanding during the period. Except when the effect would be anti-dilutive,
          the diluted EPS calculation includes the impact of shares that could be
          issued
          upon exercise of outstanding stock options, contingently issuable shares
          under
          equity-based awards or common shares that would result from the conversion
          of
          convertible notes. The numerator in calculating diluted earnings per share
          is
          Net Income adjusted for the interest on convertible notes (net of tax)
          that
          would not be paid if the notes were converted to common shares.
  22
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  The
          following table
          shows the effects of potential dilutive common stock on the weighted average
          number of shares:
  Three
                    Months
                    EndedMarch
                    31,**2006**
                
                **2005**-
                    In
                    Thousands -Numerator:Net
                    Income
                
                **$**
                **16,822**
                
                $
                (3,783
                )Income
                    from
                    Assumed Conversion of Convertible Senior Notes
                
                
                **1,128**
                
                
                -Adjusted
                    Numerator
                
                **$**
                **17,950**
                
                $
                (3,783
                )Denominator:Weighted-average
                    Shares of Common Stock Outstanding:Common
                    Shares
                    Issued
                
                
                **34,925**
                
                
                34,391Fully
                    Vested Deferred Stock
                    Units
                
                
                **191**
                
                
                192Total
                    Weighted-average
                    Shares of Common Stock Outstanding
                
                
                **35,116**
                
                
                34,583Effect
                    of
                    Dilutive Securities:Convertible
                    Senior
                    Notes
                
                
                **4,000**
                
                
                -Options
                    and Stock Issuable
                    under Employee Benefit Plansand
                    the
                    Directors’ Plan
                
                
                **618**
                
                
                -Total
                    Shares
                
                
                **39,734**
                
                
                34,583
 
 Due
          to UniSource
          Energy’s net loss for the quarter ended March 31, 2005, the following potential
          shares of common stock were excluded from the diluted EPS calculation because
          the effect would be antidilutive:
 
 ·
                1,377,780
                    shares: the $150 million aggregate principal amount of convertible
                    notes
                    issued on March 1, 2005 and convertible into 1,377,780 shares
                    (weighted
                    for the number of days outstanding in the period) at a conversion
                    price of
                    approximately $37.50 per share.
 ·
                746,937
                    incremental common shares related to options and contingently
                    issuable
                    shares.
 
 **NOTE9. 
EMPLOYEE
          BENEFITS PLANS**
 
 **PENSION
          BENEFIT PLANS**
  TEP,
          UNS Gas and UNS
          Electric maintain noncontributory, defined benefit pension plans for
          substantially all regular employees and certain affiliate employees. Benefits
          are based on years of service and the employee's average compensation.
          TEP, UNS
          Gas and UNS Electric fund the plans by contributing at least the minimum
          amount
          required under Internal Revenue Service regulations. Additionally, we provide
          supplemental retirement benefits to certain employees whose benefits are
          limited
          by Internal Revenue Service benefit or compensation limitations.
 
 **OTHER
          POSTRETIREMENT BENEFIT PLANS**
  TEP
          provides limited
          health care and life insurance benefits for retirees. All regular employees
          may
          become eligible for these benefits if they reach retirement age while working
          for TEP or an affiliate. UNS Gas and UNS Electric provide postretirement
          medical
          benefits for current retirees and a small group of active employees. The
          majority of UNS Gas and UNS Electric employees do not participate in the
          postretirement medical plan.
 
 The
          ACC allows TEP,
          UNS Gas and UNS Electric to recover postretirement costs through rates
          only as
          benefit payments are made to or on behalf of retirees. The postretirement
          benefits are currently funded entirely on a pay-as-you-go basis. Under
          current
          accounting guidance, TEP, UNS Gas and UNS Electric cannot record a regulatory
          asset for the excess of expense calculated per Statement of Financial Accounting
          Standards No. 106, *Employers’
          Accounting for Postretirement Benefits Other Than Pensions* ,
          over actual
          benefit payments.
  23
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  **COMPONENTS
          OF NET PERIODIC BENEFIT COST**
 
 The
          components of
          net periodic benefit costs are as follows:
 
 **Pension
                    Benefits**
                
                **Other
                    Postretirement**
                  **Benefits**Three
                    Months
                    Ended
                
                Three
                    Months
                    EndedMarch
                    31,
                
                March
                    31,**2006**
                
                **2005**
                
                **2006**
                
                **2005**-Millions
                    of
                    Dollars -**Components
                    of Net Periodic Benefit Cost**Service
                    Cost
                
                **$**
                **2**
                
                $
                2
                
                **$**
                **1**
                
                $
                1Interest
                    Cost
                
                
                **3**
                
                
                3
                
                
                **1**
                
                
                1Expected
                    Return on Plan
                    Assets
                
                
                **(3**
                **)**
                
                (3
                )
                
                **-**
                
                
                -Recognized
                    Actuarial
                    Loss
                
                
                **1**
                
                
                1
                
                
                **-**
                
                
                -**Net
                    Periodic Benefit Cost**
                
                **$**
                **3**
                
                $
                3
                
                **$**
                **2**
                
                $
                2
  **NOTE10. 
SHARE-BASED
          COMPENSATION
          PLANS**
 
 At
          March 31, 2006,
          we had stock options, stock units and restricted stock grants outstanding
          as
          discussed below. Effective January 1, 2005, we adopted the new accounting
          guidance for share-based compensation.
 
 **STOCK
          OPTIONS**
 
 There
          were no stock
          options granted during the three months ended March 31, 2006 and March
          31, 2005.
          Stock option awards vest over three years, become exercisable in one-third
          increments on each anniversary date of the grant and expire on the tenth
          anniversary of the grant. Compensation expense recorded for the three months
          ended March 31, 2006 and the three months ended March 31, 2005 was less
          than
          $0.1 million.
 
 A
          summary of stock
          option activity follows:
 
 Three
                    Months
                    Ended March 31,**2006**
                
                **2005****Weighted**
                
                
                
                Weighted**Average**
                
                
                
                Average**Exercise**
                
                
                
                Exercise**Shares**
                
                **Price**
                
                Shares
                
                PriceOptions
                      Outstanding, Beginning of Period
                
                
                **1,537,041**
                
                **$**
                **16.75**
                
                
                2,076,055
                
                $
                16.19Granted
                
                
                **-**
                
                
                **-**
                
                
                **-**
                
                
                **-**Exercised
                
                
                **(133,888**
                **)**
                **$**
                **15.38**
                
                
                **(**212,279
                )
                $
                16.44Forfeited
                
                
                **(1,646**
                **)**
                **$**
                **14.95**
                
                
                **(**483
                )
                $
                12.28Options
                    Outstanding, End of Period
                
                
                **1,401,507**
                
                **$**
                **16.88**
                
                
                1,863,293
                
                $
                16.16Options
                      Exercisable, End of Period
                
                
                **1,351,109**
                
                **$**
                **16.88**
                
                
                1,855,402
                
                $
                16.16Weighted
                    Average Remaining Contractual Life at March 31, 2006:
                
                4.84
                    years
 
 Stock
          options
          awarded on January 1, 2002 accrue dividend equivalents that are paid in
          cash on
          the earlier of the date of exercise of the underlying option or the date
          the
          option expires. Compensation expense is recognized as dividends are paid.
          We
          recorded compensation expense of less than $0.1 million for the three-month
          periods ended March 31, 2006 and 2005.
  24
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  **RESTRICTED
          STOCK AND STOCK UNITS**
 
 For
          the three
          months ended March 31, 2006, we granted restricted stock awards to directors
          totaling 560 shares at a grant date fair value of $31.20 per share. For
          the
          three months ended March 31, 2005, we granted restricted stock awards to
          directors totaling 6,528 shares at a grant date fair value of $24.51 per
          share.
          Directors may elect to receive stock units in lieu of restricted shares.
          Compensation expense equal to the fair market value on the date of the
          award is
          recognized over the vesting period.
 
 There
          were no new
          stock unit awards granted to directors during each of the three-month periods
          ended March 31, 2006 and 2005. When stock unit awards are granted, compensation
          expense equal to the fair market value on the date the award is granted
          is
          recorded over the vesting period specified in the award. Fully vested but
          undistributed stock unit awards accrue dividend equivalent stock units
          based on
          the fair market value of common shares on the date the dividend is paid.
          Compensation expense is recognized when dividends are paid.
 
 We
          recorded
          compensation expense for the awards described above of approximately $0.1
          million for each of the three-month periods ended March 31, 2006 and
          2005.
 
 **NOTE11. 
INCOME
          AND OTHER TAXES**
 
 **INCOME
          TAXES**
 
 The
          differences
          between the income tax expense (benefit) and the amount obtained by multiplying
          pre-tax income (loss) by the U.S. statutory federal income tax rate of
          35% are
          as follows:
 
 **UniSource
                    Energy**
                
                **TEP**Three
                    Months
                    Ended
                
                Three
                    Months
                    EndedMarch
                    31,
                
                March
                    31,**2006**
                
                **2005**
                
                **2006**
                
                **2005**-Thousands
                    of
                    Dollars -**Federal
                    Income Tax Expense (Benefit) at Statutory Rate**
                
                **$**
                **10,107**
                
                $
                (1,858
                )
                **$**
                **9,841**
                
                $
                (2,398
                )State
                    Income Tax Expense
                    (Benefit), Net of Federal Deduction
                
                
                **1,328**
                
                
                (244
                )
                
                **1,293**
                
                
                (315
                )Depreciation
                    Differences
                    (Flow Through Basis)
                
                
                **662**
                
                
                680
                
                
                **662**
                
                
                680Tax
                    Credits
                
                
                **(130**
                **)**
                
                (131
                )
                
                **(130**
                **)**
                
                (131
                )Other
                
                
                **89**
                
                
                27
                
                
                **(138**
                **)**
                
                2**Total
                    Federal and State Income Tax Expense (Benefit)**
                
                **$**
                **12,056**
                
                $
                (1,526
                )
                **$**
                **11,528**
                
                $
                (2,162
                )
  The
          total Federal
          and State Income Tax Expense (Benefit) in the table above is included in
          UniSource Energy and TEP’s income statements.
 
 **OTHER
          TAX
          MATTERS**
 
 On
          its 2002 tax
          return, TEP filed for an automatic change in accounting method relating
          to the
          capitalization of indirect costs to the production of electricity and
          self-constructed assets. The new accounting method was also used on the
          2003 and
          2004 returns for TEP, UNS Gas and UNS Electric.
 
 In
          August 2005, the
          Internal Revenue Service issued a ruling which draws into question the
          ability
          of electric and gas utilities to use the new accounting method. TEP believes
          the
          IRS position is without merit, and intends to vigorously pursue this issue.
          However, if the IRS were to prevail and disallow the change in its entirety
          TEP,
          UNS Gas and UNS Electric could be required to pay up to $19 million, $1
          million
          and $1 million, respectively, in taxes and interest in the second half
          of 2006.
          Such payment would not affect total tax expense.
 
 25
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  **OTHER
          TAXES**
 
 TEP,
          UNS Gas and
          UNS Electric act
          as conduits or
          collection agents for excise tax ( sales
          tax) as
          well as
          franchise fees
          and regulatory assessments. They record liabilities payable to governmental
          agencies when they bill their customers for these amounts. Neither the
          amounts
          billed nor payable are reflected in the income statement.
  **NOTE12. 
NEW
          ACCOUNTING
          PRONOUNCEMENTS**
 
 The
          FASB recently
          issued the following Statements of Financial Accounting Standards (FAS)
          and FASB
          Staff Positions (FSP):
 
 ·
                FAS
                    155,
                    Accounting for Certain Hybrid Financial Instruments, issued February
                    2006, permits fair valueremeasurement for any hybrid financial instrument that contains an
                    embedded derivative that had previously been bifurcated pursuant
                    to
                    Statement 133 and eliminates a restriction in Statement 140 on the
                    passive derivative instruments that a qualifying special-purpose
                    entity may hold.  FAS 155 is effective for all
                    financial instruments acquired or issued or subject to remeasurement
                    in fiscal year that begin after September 15, 2006.  We are
                    evaluating the impact of FAS 155 on our financial
                    statements.
  ·
                FSP
                    FASB
                    Technical Bulletin 85-4-1,*Accounting
                    for Life Settlement Contracts by Third-Party Investors,*issued March
                    2006, allows an investor to account for its investment in a life
                    settlement contract using either the investment method or the
                    fair value
                    method in periods subsequent to the initial recognition of the
                    investment.  Investments accounted for under the investment method
                    are initially recorded at transaction price (the amount the investor
                    pays
                    to the insured party) plus any initial direct external costs. 
                    Subsequent costs to keep the policy in force are capitalized
                    to the
                    carrying amount.  When the insured dies, the investor recognizes, in
                    the income statement, the difference between the carrying amount
                    of the
                    investment in the life settlement contract and the life insurance
                    proceeds
                    of the underlying life insurance policy.  Investments accounted for
                    under the fair value method are initially recorded at transaction
                    price
                    and are subsequently remeasured to fair value each reporting
                    period with
                    changes in fair value recognized in earnings in the period of
                    the
                    change.  FSP FASB Technical Bulletin 85-4-1 is effective for fiscal
                    years beginning after June 15, 2006.  We are evaluating the impact of
                    FSP FASB Technical Bulletin 85-4-1 on our financial
                    statements.
  26
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**
  **NOTE13. 
SUPPLEMENTAL
          CASH FLOW
          INFORMATION**
 
 A
          reconciliation of
          Net Income to Net Cash Flows - Operating Activities follows:
 
 **UniSource
                    Energy**Three
                    Months
                    EndedMarch
                    31,**2006**
                
                **2005**-Thousands
                    of
                    Dollars-**Net
                    Income**
                
                **$**
                **16,822**
                
                $
                (3,783
                )**Adjustments
                    to Reconcile Net Income****To
                    Net Cash Flows**Discontinued
                    Operations -
                    Net of Tax
                
                
                **2,669**
                
                
                1,406Depreciation
                    and
                    Amortization Expense
                
                
                **30,757**
                
                
                34,068Depreciation
                    Recorded to
                    Fuel and Other O&M Expense
                
                
                **1,910**
                
                
                1,570Amortization
                    of Transition
                    Recovery Asset
                
                
                **11,842**
                
                
                9,487Net
                    Unrealized (Gain) Loss
                    on TEP Forward Electric Sales
                
                
                **(84**
                **)**
                
                817Net
                    Unrealized Gain on TEP
                    Forward Electric Purchases
                
                
                **(886**
                **)**
                
                (1,151
                )Net
                    Unrealized Gain on MEG
                    Trading Activities
                
                
                **3,176**
                
                
                2,203Amortization
                    of Deferred
                    Debt-Related Costs included in Interest Expense
                
                
                **1,180**
                
                
                1,030Provision
                    for Bad
                    Debts
                
                
                **830**
                
                
                824Deferred
                    Income Taxes
                
                
                **28,131**
                
                
                18,942Income
                    from Equity Method
                    Entities
                
                
                **(23**
                **)**
                
                (563
                )Other
                
                
                **15,992**
                
                
                10,931Changes
                    in Assets and
                    Liabilities which Provided (Used)Cash
                    Exclusive of Changes
                    Shown SeparatelyAccounts
                    Receivable
                
                
                **7,326**
                
                
                33,571Materials
                    and Fuel
                    Inventory
                
                
                **(773**
                **)**
                
                (4,789
                )Accounts
                    Payable
                
                
                **(26,604**
                **)**
                
                (33,648
                )Interest
                    Accrued
                
                
                **(26,023**
                **)**
                
                (29,329
                )Income
                    Tax
                    Receivable
                
                
                **-**
                
                
                (5,090
                )Taxes
                    Accrued
                
                
                **(13,291**
                **)**
                
                (7,958
                )Other
                    Current
                    Assets
                
                
                **21,511**
                
                
                29,662Other
                    Current
                    Liabilities
                
                
                **(19,483**
                **)**
                
                (16,367
                )Net
                    Cash Used by
                    Operating Activities of Discontinued Operations
                
                
                **(2,710**
                **)**
                
                (1,894
                )**Net
                    Cash Flows - Operating Activities**
                
                **$**
                **52,269**
                
                $
                39,939
 
 27
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONCLUDED)**
 **TEP**Three
                    Months
                    EndedMarch
                    31,**2006**
                
                **2005**-Thousands
                    of
                    Dollars-**Net
                    Income**
                
                **$**
                **16,587**
                
                $
                (4,690
                )**Adjustments
                    to Reconcile Net Income****To
                    Net Cash Flows**Depreciation
                    and
                    Amortization Expense
                
                
                **26,501**
                
                
                30,020Depreciation
                    Recorded to
                    Fuel and Other O&M Expense
                
                
                **1,629**
                
                
                1,570Amortization
                    of Transition
                    Recovery Asset
                
                
                **11,842**
                
                
                9,487Net
                    Unrealized Gain on TEP
                    Forward Electric Sales
                
                
                **(84**
                **)**
                
                817Net
                    Unrealized (Gain) Loss
                    on TEP Forward Electric Purchases
                
                
                **(886**
                **)**
                
                (1,151
                )Amortization
                    of Deferred
                    Debt-Related Costs included in Interest Expense
                
                
                **863**
                
                
                917Provision
                    for Bad
                    Debts
                
                
                **366**
                
                
                719Deferred
                    Income Taxes
                
                
                **24,850**
                
                
                22,615Income
                    from Equity Method
                    Entities
                
                
                **(62**
                **)**
                
                (23
                )Interest
                    on Note Receivable
                    from UniSource Energy
                
                
                **-**
                
                
                (1,684
                )Other
                
                
                **8,105**
                
                
                3,129Changes
                    in Assets and
                    Liabilities which Provided (Used)Cash
                    Exclusive of Changes
                    Shown SeparatelyAccounts
                    Receivable
                
                
                **6,849**
                
                
                22,786Materials
                    and Fuel
                    Inventory
                
                
                **(1,055**
                **)**
                
                (3,373
                )Accounts
                    Payable
                
                
                **(19,755**
                **)**
                
                (16,105
                )Interest
                    Accrued
                
                
                **(21,604**
                **)**
                
                (27,171
                )Interest
                    Received
                    from UniSource Energy
                
                
                **-**
                
                
                11,013Income
                    Taxes
                    Receivable
                
                
                **(6,886**
                **)**
                
                (6,972
                )Income
                    Taxes
                    Payable
                
                
                **(17,111**
                **)**
                
                (17,815
                )Taxes
                    Accrued
                
                
                **9,206**
                
                
                9,295Other
                    Current
                    Assets
                
                
                **5,095**
                
                
                6,660Other
                    Current
                    Liabilities
                
                
                **(1,290**
                **)**
                
                (2,886
                )**Net
                    Cash Flows - Operating Activities**
                
                **$**
                **43,160**
                
                $
                37,158
  **NOTE14. 
REVIEW
          BY INDEPENDENT REGISTERED PUBLIC
          ACCOUNTING FIRM**
 
 With
          respect to the
          unaudited condensed consolidated financial information of UniSource Energy
          and
          TEP for the three-month periods
          ended March
          31, 2006 and 2005, PricewaterhouseCoopers LLP reported that they have applied
          limited procedures in accordance with professional standards for a review
          of
          such information. However, their separate report dated
          May 3, 2006
          appearing herein states that
          they did not audit and they do not express an opinion on that unaudited
          condensed consolidated financial information. Accordingly, the degree of
          reliance on their report on such information should be restricted in light
          of
          the limited nature of the review procedures applied. PricewaterhouseCoopers
          LLP
          is not subject to the liability provisions of Section 11 of the Securities
          Act
          of 1933 (the Act) for their report on the unaudited condensed consolidated
          financial information because that report is not a “report” or a “part” of a
          registration statement prepared or certified by PricewaterhouseCoopers
          LLP
          within the meaning of Sections 7 and 11 of the Act.
  28


**ITEM2.
      - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
      CONDITION AND RESULTS OF OPERATIONS**





Management’s
      Discussion and Analysis explains the results of operations, the general
      financial condition, and the outlook for UniSource Energy and its three primary
      business segments and includes the following:





·  outlook
      and
      strategies,


·  operating
      results
      during the first quarter of 2006 compared with the same period in
      2005,


·  factors
      which
      affect our results and outlook,


·  liquidity,
      capital
      needs, capital resources, and contractual obligations,


·  dividends,
      and


·  critical
      accounting
      estimates.





Management’s
      Discussion and Analysis should be read in conjunction with UniSource Energy
      and
      TEP’s 2005 Annual Report on Form 10-K and with the Condensed Consolidated
      Financial Statements, beginning on page 3, which present the results of
      operations for the three months ended March 31, 2006 and 2005. Management’s
      Discussion and Analysis explains the differences between periods for specific
      line items of the Condensed Consolidated Financial Statements.





References
      in this
      report to “we” and “our” are to UniSource Energy and its subsidiaries,
      collectively.





**UNISOURCEENERGY
      CONSOLIDATED**





**OVERVIEWOF
      CONSOLIDATED BUSINESS**





UniSource
      Energy is
      a holding company that has no significant operations of its own. Operations
      are
      conducted by UniSource Energy’s subsidiaries, each of which is a separate legal
      entity with its own assets and liabilities. UniSource Energy owns the
      outstanding common stock of TEP, UniSource Energy Services, Inc. (UES),
      Millennium Energy Holdings, Inc. (Millennium), and UniSource Energy Development
      Company (UED).





TEP,
      an electric
      utility, has provided electric service to the community of Tucson, Arizona,
      for
      over 100 years. UES began operations in 2003. UES, through its two operating
      subsidiaries, UNS Gas, Inc. (UNS Gas) and UNS Electric, Inc. (UNS Electric),
      provides gas and electric service to 30 communities in northern and southern
      Arizona. Millennium invests in unregulated businesses. UED is facilitating
      the
      expansion of the Springerville Generating Station, but currently has no
      significant operations. We conduct our business in three primary business
      segments - TEP’s Electric Utility segment, UNS Gas and UNS
      Electric.





UniSource
      Energy is
      in the process of exiting its Millennium investments. On March 31, 2006,
      Millennium sold its interest in Global Solar Energy, Inc. (Global Solar), its
      largest holding.





UniSource
      Energy
      was incorporated in the State of Arizona in 1995 and obtained regulatory
      approval to form a holding company in 1997. In 1998, TEP and UniSource Energy
      exchanged shares of stock resulting in TEP becoming a subsidiary of UniSource
      Energy. Following the share exchange, TEP transferred the stock of its
      subsidiary Millennium to UniSource Energy.




29




**OUTLOOKAND
      STRATEGIES**


**Operating Plans and Strategies**




Our financial prospects and outlook for the next few years will be affected
      by
      many competitive, regulatory and economic factors. Our plans and strategies
      include the following:





·
            Efficiently
                manage our generation, transmission and distribution resources and
                look
                for ways to control our operating expenses while maintaining and
                enhancing
                reliability and profitability.





·
            Expand
                TEP’s
                and UNS Electric’s portfolio of generating and purchased power resources
                to meet growing retail energy
                demand.





·
            Oversee
                the
                construction of Springerville Unit 3 and continue to enhance the
                value of
                existing assets by working with Salt River Project to facilitate
                the
                development of Springerville Unit
                4.





·
            Enhance
                the
                value of TEP’s transmission system while continuing to provide reliable
                access to generation for TEP and UES’ retail customers and market access
                for all generating assets.





·
            Continue
                to
                integrate UES’ businesses with UniSource Energy’s other
                businesses.





·
            Reduce
                UniSource Energy’s debt.





·
            Promote
                economic development in our service
                territories.




To accomplish our goals, during 2006 we expect to spend the following amounts
      on
      capital expenditures:





Actual
                Year-to-Date
              March
                31,
                2006
            
            Estimate
              Full
                Year
                2006-Millions
                of
                Dollars-TEP
            
            $
            47
            
            $
            160UNS
                Gas
            
            
            6
            
            
            25UNS
                Electric
            
            
            10
            
            
            35UniSource
                Energy Consolidated
            
            $
            63
            
            $
            220




While we believe that our plans and strategies will continue to have a positive
      impact on our financial prospects and position, we recognize that we continue
      to
      be highly leveraged, and as a result, our access to the capital markets may
      be
      limited or more expensive than for less leveraged companies.





**RESULTSOF
      OPERATIONS**




**Executive Overview**




In the first three months of 2006, UniSource Energy reported income from
      continuing operations of $19 million, compared with a loss from continuing
      operations of $2 million in the same period in 2005. The improvement is due
      primarily to the higher availability of TEP’s coal-fired generating plants. In
      the first quarter of 2005, Springerville Unit 2 was unavailable for six weeks
      due to a planned maintenance outage, which limited TEP’s wholesale sales
      opportunities and led to higher replacement power costs to serve retail
      customers.




On March 31, 2006, Millennium sold Global Solar for $16 million in cash. In
      addition, Millennium received an option to purchase, under certain conditions,
      5% to 10% of Global Solar in the future. In the first quarter of 2006,
      UniSource Energy recorded an after-tax loss of approximately $3 million related
      to the discontinued operations and disposal of Global Solar.




30




**CONTRIBUTIONBY
      BUSINESS
      SEGMENT**





The
      table below
      shows the contributions to our consolidated after-tax earnings by our three
      business segments and Other net income (loss).





**Three
                Months Ended March 31,**
            
            **2006**
            
            **2005**-Millions
                of
                Dollars-TEP
            
            $
            17
            
            $
            (5
            )UNS
                Gas
            
            
            5
            
            
            4UNS
                Electric
            
            
            1
            
            
            1Other(1)
            
            
            (3
            )
            
            (2
            )Consolidated
                Net Income (Loss) fromContinuing
                Operations
            
            $
            20
            
            $
            (2
            )Discontinued
                Operations(2)
            
            
            (3
            )
            
            (2
            )Consolidated
                Net Income (Loss)
            
            $
            17
            
            $
            (4
            )




(1) Includes:
      UniSource
      Energy parent company expenses; UniSource Energy parent company interest expense
      (net of tax) on the UniSource Energy Convertible Senior Notes and on the
      UniSource Energy Credit Agreement; income and losses from Millennium
      investments; in the first three months of 2005, interest expense (net of tax)
      on
      the note payable from UniSource Energy to TEP.





(2) Relates
      to the
      discontinued operations and sale of Global Solar by Millennium on March 31,
      2006.





**Three
      Months Ended March 31, 2006 Compared with the Three Months Ended March 31,
      2005**





UniSource
      Energy
      recorded income from continuing operations of $19 million, or 56 cents per
      average basic share of Common Stock, in the first quarter of 2006, compared
      with
      a loss from continuing operations of $2 million, or 7 cents per average basic
      share of Common Stock, in the same period of 2005. The following factors
      contributed to the improvement:





2006
      included:




· $23
      million
      increase in TEP’s gross margin (the sum of retail and wholesale electric
      revenues less fuel and purchased power expense) due to the
      following:




-
            $17
                million
                increase in wholesale revenues due to the higher use and availability
                of
                TEP’s coal-fired generating plants and increased wholesale activity.
                In
                the first quarter of 2005, TEP’s 380 MW Springerville Unit 2 was down for
                6 weeks for scheduled maintenance;





-
            $9
                million
                increase in retail revenues; and





-
            $3
                million
                increase in fuel expense due to higher output from TEP’s coal-fired
                generating plants.





· a
      $6
      million decrease in other operations and maintenance (O&M) due primarily to
      fewer TEP coal plant outages in the first quarter of 2006 compared with the
      same
      period last year;




·  $3
      million decline
      in depreciation and amortization due primarily to the extension of useful lives
      of certain assets at TEP in 2005; and




·  $3
      million decrease
      in total interest expense due to: lower fees under TEP’s new Credit Agreement
      entered into in May 2005; the repurchase and redemption of $225 million of
      TEP
      debt in May 2005; and lower capital lease obligation balances.




31





**LIQUIDITYAND
      CAPITAL
      RESOURCES**





**UNISOURCE
      ENERGY CONSOLIDATED CASH FLOWS**





**Three
                Months Ended March 31,**
            
            **2006**
            
            **2005**-Millions
                of
                Dollars-Cash
                provided
                by (used in):Operating
                Activities
            
            $
            52
            
            $
            40Investing
                Activities
            
            
            (51
            )
            
            (31
            )Financing
                Activities
            
            
            (22
            )
            
            41Net
                Increase
                (Decrease) in Cash
            
            $
            (21
            )
            $
            50





UniSource
      Energy’s
      consolidated cash flows are provided primarily from retail and wholesale energy
      sales at TEP, UNS Gas and UNS Electric, net of the related payments for fuel
      and
      purchased power. Generally, cash from operations is lowest in the first quarter
      and highest in the third quarter due to TEP’s summer peaking load.





We
      use our
      available cash primarily to:


· fund
      capital expenditures at TEP, UNS Gas and UNS Electric;


· pay
      dividends to shareholders; and


· reduce
      leverage.





The
      primary source
      of liquidity for UniSource Energy, the parent company, is dividends it receives
      from its subsidiaries, primarily TEP. Also, under our tax sharing agreement,
      our
      subsidiaries make income tax payments to UniSource Energy, which makes payments
      on behalf of the consolidated group.





As
      of May 2, 2006,
      cash and cash equivalents available to UniSource Energy was approximately $132
      million.





**Executive
      Overview**





In
      the first three
      months of 2006, net cash flows from operating activities were $52 million,
      up
      $12 million from the same period in 2005. The improvement is due primarily
      to
      the higher availability and use of TEP’s coal-fired generating plants to serve
      retail customers and for sales of excess energy into the wholesale market.





**Operating
      Activities**





In
      the first three
      months of 2006, net cash flows from operating activities increased by $12
      million compared with the same period in 2005. The following factors contributed
      to the change:





2006
      included:





·
            $5
                million
                increase in cash receipts from retail electric sales due primarily
                to
                customer growth at TEP and UNS
                Electric;





·
            $11
                million
      increase in cash receipts from UNS Gas’ retail sales due to the Purchased
                Gas Adjustor (PGA) surcharge adjustments that took effect in November
                2005
                and customer growth;





·
            $27
                million
                increase in cash receipts from wholesale electric sales due to the
                higher
                amount of excess output from TEP’s coal-fired generating plants, as well
                as higher market prices for wholesale power;





·
            $3
                million
                increase in fuel costs paid due to the higher availability and use
                of
                TEP’s coal-fired generating plants;





·
            $28
                million
                increase in purchased energy costs paid due to higher wholesale trading
                activity at TEP and higher retail sales and natural gas prices at
                UNS Gas;





·
            $7
                million
                decrease in payments for O&M costs. O&M costs were higher in the
                first three months of 2005 due to higher frequency and duration of
                planned
                and unplanned outages at TEP’s coal
                plants;




32





·
            $6
                million
                decrease in total interest costs paid due to lower amounts of outstanding
                long-term debt and capital lease obligations;
                and





·
            $6
                million
                increase in income taxes paid due to higher pre-tax
                income.





**Investing
      Activities**





Net
      cash used for
      investing activities was $20 million higher in the three months of 2006 compared
      with the same period in 2005, due primarily to an $18 million increase in
      capital expenditures. The increase in capital expenditures is related to TEP’s
      share of the construction costs of the Luna Energy Facility (Luna), growth
      and
      maintenance of TEP’s electric system, and utility system growth at UNS Gas and
      UNS Electric.





**Financing
      Activities**





Net
      cash flows used
      for financing activities were $64 million higher in the three months of 2006
      compared with the same period in 2005. The following factors contributed to
      the
      change:





2006
      included:





·
            $32
                million
                of net proceeds from borrowings under revolving credit
                facilities;





·
            $2
                million
                increase in TEP’s payments on capital lease obligations;
                and





·
            $1
                million
                increase in dividends paid to UniSource Energy
                shareholders.





2005
      included:





·
            $150
                million
                of proceeds related to UniSource Energy’s issuance of Convertible Senior
                Notes in March 2005; and





·
            the
                use of
                $53 million by TEP to redeem 1941 Mortgage Bonds in March
                2005.





As
      a result of the
      activities described above, our consolidated cash and cash equivalents decreased
      to $123 million at March 31, 2006, from $145 million at December 31, 2005.
      We
      invest cash balances in high-grade money market securities with an emphasis
      on
      preserving the principal amounts invested.





At
      May 2, 2006, our
      consolidated cash balance, including cash equivalents, was approximately $132
      million.





We
      believe that we
      will continue to have sufficient cash flow to cover our capital needs, as well
      as required debt payments and dividends to shareholders. In the event that
      we
      experience lower cash from operations in 2006, we will use our revolving credit
      facilities to fund our cash needs.





UniSource
      Credit
      Agreement




In
      April 2005,
      UniSource Energy entered into a $105 million five-year credit agreement with
      a
      group of lenders (UniSource Credit Agreement) which expires in April 2010.
      The
      UniSource Credit Agreement includes a term loan facility with an outstanding
      balance of $85 million as of March 31, 2006, and a $15 million revolving credit
      facility. Principal payments of $1.25 million are due at each quarter end with
      the balance due at maturity. As of March 31, 2006, UniSource Energy was in
      compliance with the terms of the UniSource Credit
      Agreement.





We
      expect that we may borrow from time to time under the revolving credit facility
      to meet temporary cash needs. As of March 31, 2006, we had no borrowings
      outstanding under the revolving credit facility.





See
      below for
      further discussion of Liquidity and Capital Resources for each of UniSource
      Energy’s reportable segments.




33




**GUARANTEES
      AND INDEMNITIES**





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 at March 31, 2006 are:





-
            UES’
                guarantee of $160 million of senior unsecured notes issued by UNS
                Gas and
                UNS Electric to purchase the Citizens Communication Company (Citizens’)
                Arizona gas and electric system assets;


-
            UES’
                guarantee of a $40 million revolving credit facility available to
                UNS Gas
                and UNS Electric;


-
            UniSource
                Energy’s guarantee of approximately $8 million in natural gas and supply
                payments and building lease payments for UNS Gas and UNS Electric
                and a
                subsidiary of Millennium.





To
      the extent liabilities exist under the contracts subject to these guarantees,
      such liabilities are included in the consolidated balance sheets.





In
      addition,
      UniSource Energy and its subsidiaries have indemnified the purchasers of
      interests in certain investments from additional taxes due for years prior
      to
      the sale. The terms of the indemnifications provide for no limitation on
      potential future payments; however, we believe that we have abided by all tax
      laws and paid all tax obligations. We have not made any payments under the
      terms
      of these indemnifications to date.





We
      believe that the
      likelihood that UniSource Energy or TEP would be required to perform or
      otherwise incur any significant losses associated with any of these guarantees
      is remote.





**CONTRACTUAL
      OBLIGATIONS**





There
      are no
      significant changes in our contractual obligations or other commercial
      commitments from those reported in our 2005 Annual Report on Form 10-K, other
      than:





·
            At
                March 31,
                2006, TEP has commitments to pay various home builders $2 million
                in
                builder incentives through 2007 to construct TEP Guarantee Homes
                that meet
                the highest construction and energy-efficiency standards
                available.


·
            TEP
                entered
                into operating leases in the first quarter 2006 for large equipment
                at
                Springerville totaling $2 million over three
                years.


·
            In
                May 2006,
                UNS Electric entered into a 25 MW power supply agreement with Credit
                Suisse for the period June 2008 through December 2013. The 25 MW
                consists of 10 MW at fixed price with the remaining 15 MW price indexed
                to
                natural gas prices. UNS Electric’s minimum expected annual payment under
                this contract is $9 million.





**DIVIDENDS
      ON COMMON STOCK**





The
      following table
      shows the dividends declared to UniSource Energy shareholders for
      2006.





**Declaration
                Date**
            **Record
                Date**
            **Payment
                Date**
            **Dividend
                Amount**
              **Per
                Share of Common Stock**February
                10,
                2006
            February
                21,
                2006
            March
                15,
                2006
            $0.21




**INCOME
      TAX
      MATTERS**




Income
      Tax
      Position





At
      March 31, 2006,
      UniSource Energy and TEP had, for federal income tax filing purposes, Federal
      AMT Credit carryforward amounts of $70 million and $55 million, respectively.




Internal
      Revenue
      Service Matters





On
      its 2002 tax
      return, TEP filed for an automatic change in accounting method relating to
      the capitalization
      of
      indirect costs to the production of electricity and self-constructed assets.
      The
      new accounting method was also used on the 2003 and 2004 returns for TEP, UNS
      Gas and UNS Electric.




34





In
      August 2005, the
      Internal Revenue Service (IRS) issued a ruling which draws into question the
      ability of electric and gas utilities to use the new accounting method. TEP
      believes the IRS position is without merit and intends to vigorously pursue
      this
      issue. However, if the IRS were to prevail and disallow the change in its
      entirety, TEP, UNS Gas and UNS Electric could be required to pay up to $19
      million, $1 million and $1 million, respectively, in taxes and pay an
      appropriate amount of interest in 2006. Such payments would not affect total
      tax
      expense.




**TUCSONELECTRIC
      POWER COMPANY**





**RESULTSOF
      OPERATIONS**





The
      financial
      condition and results of operations of TEP are currently the principal factors
      affecting the financial condition and results of operations of UniSource Energy
      on an annual basis. The following discussion relates to TEP’s utility
      operations, unless otherwise noted.




**Sales**
            
            **Operating
                Revenue****Three
                Months Ended March 31,**
            
            **2006**
            
            **2005**
            
            **2006**
            
            **2005**-Millions
                of
                kWh-
            
            -Millions
                of
                Dollars-**Electric
                Retail Sales:**Residential
            
            
            699
            
            
            649
            
            $
            59
            
            $
            55Commercial
            
            
            389
            
            
            351
            
            
            40
            
            
            36Industrial
            
            
            508
            
            
            512
            
            
            36
            
            
            36Mining
            
            
            224
            
            
            220
            
            
            10
            
            
            10Public
                Authorities
            
            
            54
            
            
            44
            
            
            4
            
            
            3**Total
                Electric Retail Sales**
            
            
            1,874
            
            
            1,776
            
            $
            149
            
            $
            140**Electric
                Wholesale Sales Delivered:**Long-term
                Contracts
            
            
            292
            
            
            308
            
            
            14
            
            
            14Other
                Sales
            
            
            725
            
            
            454
            
            
            41
            
            
            24Transmission
            
            
            -
            
            
            -
            
            
            2
            
            
            2Net
                Unrealized (Loss) Gain on Forward Sales of Energy
            
            
            -
            
            
            -
            
            
            -
            
            
            (1
            )**Total
                Electric Wholesale Sales**
            
            
            1,017
            
            
            762
            
            
            57
            
            
            39**Total
                Electric Sales**
            
            
            2,891
            
            
            2,538
            
            $
            206
            
            $
            179**Weather
                Data:**
            
            
            **2006**
            
            
            **2005****Heating
                Degree Days**Three
                Months Ended
                March 31,
            
            
            723
            
            
            77510-Year
                Average
            
            
            812
            
            
            807





Total
      revenues from
      kWh sales to retail customers increased by $9 million in the first quarter
      of
      2006, compared with the same period last year. The total number of retail
      customers as of March 31, 2006, was approximately 387,000, an increase of 2%
      in
      the last year.





Wholesale
      revenues
      increased $18 million, or 44%, in the first quarter of 2006 compared with the
      first quarter of 2005, primarily due to the higher availability of TEP’s coal
      plants, higher power sales prices and increased wholesale activity. In the
      first
      quarter of 2005, Springerville Unit 2 underwent a six week scheduled outage.
      The
      average wholesale market price of energy was $49 per MWh in the first quarter
      of
      2006, compared with $45 per MWh in the comparable period in 2005. TEP had hedged
      270,000 MWh of its first quarter sales in the latter part of 2005 at an average
      price of $70 per MWh, which was more than 40% higher than the average wholesale
      market price. See *Factors
      Affecting Results of Operations, Western Energy Markets, Market Prices,* below.




35




**OPERATING
      EXPENSES**





**Fuel
      and
      Purchased Power Expense**





TEP’s
      fuel and
      purchased power expense, and energy resources for the first quarters of 2006
      and
      2005 are shown in the table below.




**Generation**
            
            **Expense****Three
                Months Ended March 31,**
            
            **2006**
            
            **2005**
            
            **2006**
            
            **2005**-Millions
                of
                kWh-
            
            -Millions
                of
                Dollars-Coal-Fired
                GenerationFour
                Corners
            
            
            205
            
            
            195
            
            $
            3
            
            $
            3Navajo
            
            
            279
            
            
            242
            
            
            4
            
            
            3San
                Juan
            
            
            634
            
            
            617
            
            
            14
            
            
            14Springerville
            
            
            1,527
            
            
            1,144
            
            
            25
            
            
            19Sundt
                4
            
            
            153
            
            
            207
            
            
            3
            
            
            4Total
                Coal-Fired Generation
            
            
            2,798
            
            
            2,405
            
            $
            49
            
            $
            43Gas-Fired
                Generation
            
            
            35
            
            
            56
            
            
            1
            
            
            4Solar
                and
                Other
            
            
            2
            
            
            2
            
            
            -
            
            
            -Total
                Generation
            
            
            2,835
            
            
            2,463
            
            $
            50
            
            $
            47Purchased
                Power
            
            
            310
            
            
            265
            
            
            13
            
            
            13Total
                Resources
            
            
            3,145
            
            
            2,728
            
            $
            63
            
            $
            60Less
                Line
                Losses and Company Use
            
            
            (254
            )
            
            (190
            )Total
                Energy
                Sold
            
            
            2,891
            
            
            2,538





Total
      fuel expense
      at TEP’s generating plants was $3 million higher in the first quarter of 2006
      compared with the same period last year. Coal-fired generation increased 393,000
      MWh, or 16%, compared with the first quarter of 2005 primarily due to a planned
      outage at Springerville Unit 2 during the first quarter of last year, as well
      as
      several other planned and unplanned outages. As a result of higher coal
      generation, coal-related fuel expense increased $6 million in the first three
      months of 2006 compared with the same period last year. Gas-fired generation
      decreased by 21,000 MWh and gas-related fuel expense was $3 million lower than
      the first quarter of 2005, due to the higher availability of TEP’s coal plants.
      Gas-fired generation reported in the table above includes energy generated
      at
      Luna during its test phase, but does not include any associated costs which
      are
      capitalized and reported as project costs.





Purchased
      power
      expense was unchanged in the first three months of 2006 compared with the same
      period last year. Total purchases were up 45,000 MWh, or 17%, in the first
      three
      months of 2006 compared with the same period last year; and the average price
      paid per MWh decreased 13% compared with last year.





The
      table below
      shows the average cost per kWh for TEP’s generating plants by fuel type and
      purchased power.





**Three
                Months Ended March 31,****2006**
            **2005**-cents
                per
                kWh-Coal
            1.76
            1.76Gas
            8.53*
            8.68Average
                All
                Fuels
            1.77
            1.92Purchased
                Power
            4.24
            4.86





*
      In 2006, the average cost of gas generation per kWh excludes test energy
      produced at Luna and the associated fuel costs.





**Other
      Operating Expenses**




Other
      O&M
      expense decreased $6 million in the first quarter of 2006, compared with the
      same period last year. In the first quarter of 2005, O&M included expenses
      related to the scheduled outage of Springerville Unit 2 as
      well as several
      other plant outages. TEP sold excess SO 2 Emission
      Allowances and recorded pre-tax gains of




36





$2
      million to O&M
      during the first quarters of 2006 and 2005. See *Factors
      Affecting Results of Operations, Emission Allowances,*below.




Depreciation
      and
      amortization decreased $4 million in the first quarter of 2006 compared with
      the
      same period last year, primarily due to changes in depreciation lives of certain
      assets at TEP.





Amortization
      of the
      Transition Recovery Asset (TRA) increased $2 million in the first quarter of
      2006 compared with the same period last year. Amortization of the TRA is the
      result of the Settlement Agreement with the ACC, which changed the accounting
      method for TEP’s generation operations. This item reflects the recovery, through
      2008, of transition recovery assets which were previously regulatory assets
      of
      the generation business. The amount of amortization is a function of the TRA
      balance and total kWh consumption by TEP’s distribution customers.





The
      table below
      shows estimated annual TRA amortization and unamortized TRA year-end balances
      for 2006 through 2008.





**Estimated**
            
            **Unamortized****TRA
                Amortization**
            
            **TRA
                Balance**-Millions
                of
                Dollars-2006
            
            $
            66
            
            $
            1022007
            
            
            76
            
            
            262008
            
            
            26
            
            
            -





**Other
      Income (Deductions)**





In
      the first three
      months of 2005, TEP’s Income Statement included inter-company Interest Income of
      $2 million. This represented Interest Income on a promissory note TEP received
      from UniSource Energy in exchange for the transfer to UniSource Energy of its
      stock in Millennium in 1998. UniSource Energy repaid the inter-company
      promissory note on March 1, 2005. On UniSource Energy’s Consolidated Statement
      of Income, this Interest Income, as well as UniSource Energy’s related interest
      expense, was eliminated as an inter-company transaction.





**Interest
      Expense**





Total
      interest
      expense decreased by $6 million in the first quarter of 2006 due to debt
      retirements at TEP and lower fees under the TEP Credit Agreement entered into
      in
      May 2005.





**Income
      Tax
      Expense**





Income
      tax expense
      increased $14 million in the first quarter of 2006 compared with the same period
      in 2005, due to higher pre-tax income.





**FACTORSAFFECTING
      RESULTS OF
      OPERATIONS**




**COMPETITION**





In
      2001, all of TEP’s retail customers became eligible to choose an alternative
      energy service provider (ESP), however only a small number of commercial and
      industrial customers initially chose an ESP. By 2002, none of TEP’s retail
      customers were served by an alternate ESP.





In
      January 2005, an Arizona Court of Appeals decision became final in which the
      Court held invalid certain portions of the ACC rules on retail competition
      and
      related market pricing. In February 2006, the ACC Staff requested that a
      proceeding be opened to address the issue of retail electric competition. We
      cannot predict what changes, if any, the ACC will make to the competition rules.
      Unless and until the ACC clarifies the competition rules and ESPs begin to
      offer
      to provide energy in TEP’s service area, it may not be possible for TEP’s retail
      customers to choose other energy providers. TEP has met all conditions required
      by the ACC to facilitate electric retail competition, including ACC approval
      of
      TEP’s direct access tariffs. See *Rates* , *Motion
      to Amend
      the Settlement Agreement,* below.





TEP
      competes
      against gas service suppliers and others that provide energy services. Other
      forms of energy technologies may provide competition to TEP’s services in the
      future, but to date, are not financially viable




37




alternatives
      for
      its retail customers. Self-generation by TEP’s large industrial customers could
      also provide competition for TEP’s services in the future, but has not had a
      significant impact to date.





In
      the wholesale
      market, TEP competes with other utilities, power marketers and independent
      power
      producers in the sale of electric capacity and energy.





**RATES**





**Settlement
      Agreement**




In
      1999, the ACC
      approved the Retail Electric Competition Rules (Rules) that provided a framework
      for the introduction of retail electric competition in Arizona, as well as
      the
      Settlement Agreement between TEP and certain customer groups related to the
      implementation of retail electric competition in Arizona.




The
      Rules and the
      Settlement Agreement established:





·
            a
                period from
                November 1999 through 2008, for TEP to transition its generation
                assets
                from a cost of service based rate structure to a market, or competitive,
                rate structure;


·
            the
                recovery
                through rates during the transition period of $450 million of stranded
                generation costs through a fixed competitive transition charge (fixed
                CTC);


·
            capped
                rates
                for TEP retail customers through
                2008;


·
            an
                ACC
                interim review of TEP retail rates in
                2004;


·
            unbundling
                of
                electric services with separate rates or prices for generation,
                transmission, distribution, metering, meter reading, billing and
                collection, and ancillary services;


·
            a
                process for
                ESPs to become licensed by the ACC to sell generation services at
                market
                prices to TEP retail customers;


·
            access
                for
                TEP retail customers to buy market priced generation services from
                ESPs
                beginning in 2000 (currently, no TEP customers are purchasing generation
                services from ESPs);


·
            transmission
                and distribution services would remain subject to regulation on a
                cost of
                service basis; and


·
            beginning
                in
                2009, TEP’s generation would be market based and its retail customers
                would pay the market rate for generation
                services.




Motion
      to Amend
      the Settlement Agreement





In
      September 2005,
      TEP filed a motion and supporting testimony with the ACC to amend the Settlement
      Agreement. In the motion, TEP proposed the following amendments to extend the
      benefits and protections set forth in the Settlement Agreement and provide
      additional price stability for TEP customers:





(1)
            The
                extension
                of the existing rate freeze at TEP’s current average retail base rate of
                8.3 cents per kWh through December 31, 2010;





(2)
            The
                retention
                of the current CTC amortization
                schedule;





(3)
            The
                agreement
                of TEP not to seek base rate treatment for certain generating assets
                in
                order to minimize the rates TEP’s customers will eventually pay once the
                rate freeze has expired; and





(4)
            The
                implementation of an energy cost adjustment mechanism to protect
                TEP and
                its customers from energy market volatility, to be effective after
                December 31, 2008. TEP proposes the establishment of an incremental
                Energy
                Cost Adjustment Clause (ECAC). A base amount of retail energy consumption
                would be served at the existing fixed retail rates and the rate on
                the
                incremental amount of retail energy would be capped at an annual
                proxy set
                at forward power prices.





In
      October 2005, a number of participants in TEP’s rate proceedings, including the
      Staff of the ACC, filed responses to TEP’s motion. Those responses reflect
      differing interpretations of the Settlement Agreement which established TEP’s
      existing rate structure and generation service rates. Responses filed by ACC
      Staff and the Residential
      Utility
      Consumer Office disputed TEP’s assertion that the existing rate structure
      contemplates market-based rates for generation services after December 31,
      2008.




38




On
      January 30, 2006, an ACC administrative law judge (ALJ) issued a recommended
      opinion and order, which if adopted by the ACC, would have denied TEP’s motion
      to amend the Settlement Agreement and ordered TEP to file a rate case no later
      than September 30, 2007, using a test year no earlier than December 31,
      2006.





**ACC
      Order
      to Review the Settlement Agreement**





On
      April 12, 2006, during a special open meeting, the ACC considered TEP’s motion
      to amend the Settlement Agreement and the ALJ’s recommended opinion and order,
      and issued an order which finds:





·
            the
                meaning
                of the Settlement Agreement and its effect on how TEP’s rates for
                generation services will be determined after December 31, 2008 is
                in
                dispute;





·
            it
                is in the
                public interest to resolve, as soon as possible, the
                dispute;





·
            a
                hearing
                should be held to consider the Settlement Agreement. The hearing
                should
                address the following issues, but not limited to: the viability of
                the
                Settlement Agreement in light of the ACC’s Track A and Track B proceedings
                and the court decision which invalidated portions of the ACC’s rules on
                retail competition and related market pricing; a discussion and
                presentation of the evidence regarding whether TEP will be able to
                charge
                market-based or cost-of-service rates after 2008; TEP’s proposed
                amendments to the Settlement Agreement; demand side management; renewable
                energy standards; and time of use
                tariffs;





·
            the
                proceeding should fully explore various means for resolving whether
                the
                Settlement Agreement should remain in full force and effect; be unwound;
                be amended; or be novated; and





·
            orders
                a
                procedural schedule to be established that should allow for an expeditious
                but complete review of these
                matters.





A
      procedural conference has been scheduled for May 18, 2006 to determine a process
      for reviewing the Settlement Agreement as ordered by the ACC. TEP does not
      know
      when a procedural order will be issued and cannot predict whether the ACC will
      adopt TEP’s proposed amendments to the Settlement Agreement.




**2004
      General Rate Case Information**





In
      June 2004, as
      required by the Settlement Agreement, TEP filed general rate case information
      with the ACC. TEP’s filing does not propose any change in retail rates, and
      under the terms of the Settlement Agreement, no rate case filed by TEP through
      2008 may result in a net rate increase. However, absent the restriction on
      raising rates, TEP believes that the data in its filing would justify an
      increase in retail rates of 16%.





The
      general rate
      case information uses a historical test year ended December 31, 2003 and
      establishes, based on TEP’s standard offer service, that TEP is experiencing a
      revenue deficiency of $111 million. The rate case information includes, among
      other things, Springerville Unit 1 costs and other generation costs including
      fuel costs in excess of those recovered through existing rates. The proposed
      weighted cost of capital for the test year ended December 31, 2003 is 8.78%,
      including an 11.5% return on equity (increased from 10.67% currently
      authorized). The rate case information uses a hypothetical 40% equity
      capitalization (excluding capital lease obligations) rather than the
      hypothetical 37.5% equity capitalization used in TEP’s last general rate case.
      As a result of the inter-company note repayment and the debt repurchases and
      redemptions made in 2005, TEP’s equity capitalization (excluding capital lease
      obligations) at March 31, 2006 improved to 41.1%.





In
      June 2005,
      intervenor testimony in TEP’s 2004 rate review was due and several intervenors
      filed their respective testimony. None of the intervenor testimony filed
      proposed any increase or decrease to TEP’s rates. In July 2005, the ALJ issued a
      procedural order suspending the remaining testimony filing deadlines and hearing
      in the 2004 rate review. The order indicated that the ALJ will evaluate the
      parties’ positions and the need for further proceedings.




Despite
      TEP’s
      position that it has a revenue deficiency and the intervenor testimony
      recommending no change in rates, the ACC could conclude during this 2004 rate
      review process that TEP should decrease rates; any such determination would
      be
      strongly opposed by TEP.




39




Transition




The
      Settlement Agreement provides that TEP’s fixed CTC will expire when TEP’s $450
      million transition asset is fully amortized and recovered or on December 31,
      2008, whichever is earlier. Based on current projections of retail sales, the
      TRA is expected to be fully amortized by mid-2008. The Settlement Agreement
      also
      specifies that TEP’s floating competitive transition charge (floating CTC) will
      expire on December 31, 2008. This charge, which moves inversely to changes
      in
      market-based generation services rates, presently appears as a credit on retail
      customer bills. Based on current forward pricing in the wholesale energy
      markets, TEP anticipates that the floating CTC will continue to appear as a
      credit on retail customer bills through 2008. After the expiration of the
      floating CTC, TEP’s rates for generation services should be market-based.





Absent
      any other
      change to TEP’s retail rate structure, TEP estimates that the expiration of the
      fixed CTC in 2008 (which has provided revenues, on average of approximately
      one
      cent per kWh sold, or approximately $90 million annually) would result in a
      decrease in retail revenues of approximately 12% relative to revenues from
      current retail rates. However, absent any other change except the expiration
      of
      the fixed CTC, the expiration in 2008 of the floating CTC would result in
      market-based generation services rates which would, based on current pricing
      in
      the wholesale energy markets, produce a significant retail rate increase in
      January 2009.




We
      are operating
      pursuant to the Settlement Agreement. However, we cannot predict the future
      rate
      methodologies for TEP which the ACC could authorize, including whether the
      ACC
      will permit or require market-based rates for generation services, reinstate
      cost of service ratemaking for all or a portion of TEP’s generation services or
      require an alternate methodology to determine rates for TEP’s generation
      services. Under any circumstances, TEP will seek appropriate recovery and return
      on its investment in assets used to serve its customers.





TEP
      expects that,
      in establishing future rates, TEP and the ACC will review the entirety of the
      retail rate structure rather than focusing solely on any one of the elements
      noted above. Although TEP is unable to predict the type and level of future
      retail rates, TEP believes that the 2004 general rate case information filed
      with the ACC evidences that there have been a number of factors that have
      changed since the Settlement Agreement was approved that justify increasing
      or
      maintaining retail rates at current levels.





**WESTERN
      ENERGY MARKETS**





As
      a participant in
      the western U.S. wholesale power markets, TEP is directly and indirectly
      affected by changes in market conditions and market participants. TEP competes
      with other utilities, power marketers and independent power producers in the
      sale of electric capacity and energy at market-based rates in the wholesale
      market.





By
      the end of 2006,
      electric generating capacity in Arizona is expected to be 25,895 MW; an increase
      of 64% since 2001. A majority of the growth over the last three years is the
      result of 17 new or upgraded gas-fired generating units with a combined capacity
      of approximately 9,700 MW. The completion of Springerville Unit 3, which is
      expected in the third quarter of 2006, will provide 400 MW of new coal-fired
      generation .





**Market
      Prices**





The
      average market
      price for around-the-clock energy based on the Dow Jones Palo Verde Index
      increased in the first quarter of 2006, as did the average price for natural
      gas
      based on the Permian Index. Average market prices for around-the-clock energy
      have continued to increase since 2003, primarily due to high natural gas prices.
      We cannot predict whether these higher prices will continue, or whether changes
      in various factors that influence demand and supply will cause prices to change
      during 2006.





**Average
                Market Price for Around-the-Clock Energy**
            
            **$/MWh**Quarter
                ended
                March 31, 2006
            
            $
            49Quarter
                ended
                March 31, 2005
            
            
            45**Average
                Market Price for Natural Gas**
            
            
            **$/MMBtu**Quarter
                ended
                March 31, 2006
            
            $
            7.14Quarter
                ended
                March 31, 2005
            
            
            5.55




In
      addition to energy
      from its coal-fired facilities, TEP typically uses purchased power, supplemented
      by generation from its gas-fired units, to meet the summer peak demands of
      its
      retail customers. Some of these




40




purchased
      power
      contracts are price indexed to natural gas prices. Short-term and spot power
      purchase prices are also closely correlated to natural gas prices . Due
      to its
      increasing seasonal gas and purchased power usage, TEP hedges a portion of
      its
      total natural gas exposure from plant fuel and gas-indexed purchased power
      with
      fixed price contracts for a maximum of three years. TEP currently has
      approximately 60% of this exposure hedged for the summer peak period of 2006
      at
      a weighted average price of $5.95 per MMBtu. TEP purchases its remaining gas
      fuel needs and purchased power in the spot and short-term markets.





Market
      prices may
      also affect TEP’s wholesale revenues. TEP commits to future sales of energy as
      part of its ongoing efforts to hedge its excess generation based on projected
      generation capability, forward prices and generation costs. For 2006 and 2007,
      TEP has sold forward approximately 50 MW of fixed price energy at an average
      approximate price of $70 per MWh. In 2006, this energy sale excludes on-peak
      hours in June through September, and in 2007, excludes on-peak hours in April
      through September.





We
      expect the
      market price and demand for capacity and energy to continue to be influenced
      by
      factors including:





· the
      availability and price of natural gas;


·  weather;


·  continued
      population growth in the western U.S.;


·  economic
      conditions
      in the western U.S.;


·  availability
      of
      generating capacity throughout the western U.S.;


·  the
      extent of
      electric utility industry restructuring in Arizona, California and other western
      states;


·  the
      effect of FERC
      regulation of wholesale energy markets;


·  availability
      of
      hydropower;


·  transmission
      constraints; and


·  environmental
      regulations and the cost of compliance.





**LUNA
      ENERGY
      FACILITY**





In
      April 2006, the gas-fired combined cycle Luna plant commenced commercial
      operation. TEP’s one-third share of the plant’s capacity is 190 MW. Luna
      increases TEP’s total generating capacity by nearly 10%, to 2,194 MW, and will
      allow TEP to displace some of its less efficient gas-fired generation and
      purchased power. TEP’s total investment of $47 million was under budget and
      funded with internal cash.





**COAL
      SUPPLY**





In
      2003, TEP
      entered into an agreement for the purchase of coal to supply Sundt Unit 4
      through 2006. TEP issued a Request for Proposal for Sundt coal in March 2006
      and
      expects to negotiate a replacement supply contract by the end of the third
      quarter of 2006. Based on current coal market conditions, we expect the price
      TEP will pay for coal at Sundt Unit 4 after 2006 to be above existing prices.
      In
      2007, the impact on TEP’s total coal-related fuel expense across all of its
      plants is expected to increase by 2-3%.





**EMISSION
      ALLOWANCES**





TEP
      has
      SO 2 Emission
      Allowances in excess of what is required to operate its generating units. The
      excess results primarily from a higher removal rate of SO 2 emissions at
      Springerville Units 1 and 2 following recent upgrades to environmental plant
      components and related changes to plant operations. From time to time, TEP
      will
      sell a portion of its excess SO 2 Emission
      Allowances. The table below summarizes sales in 2005 and forward sales of
      SO 2 Emission
      Allowances, as of March 31, 2006.




**Delivery**
              **Allowances
                  Sold**
              **Estimated**
                **Pre-tax
                  Gain (millions)**2005
              15,000
              $1320061st
                  Quarter
              2,500
              22nd
                  Quarter
              2,500
              23rd
                  Quarter
              5,000
              32007
              10,000
              8




41




Excluding
      the
      forward sales at March 31, 2006, TEP expects to have approximately 20,000
      additional excess SO 2 Emission
      Allowances available for sale in future periods.





**SPRINGERVILLE
      UNITS 3 AND 4**





Springerville
      Unit
      3 will consist of a 400 MW coal-fired generating facility at the same site
      as
      Springerville Units 1 and 2. Tri-State will lease 100% of Unit 3 from a
      financial owner. When Unit 3 is built, TEP will allocate the fixed costs of
      the
      existing common facilities over the additional generating unit. TEP will operate
      Unit 3 and upon the completion of construction, expects to receive annual
      pre-tax benefits of approximately $15 million in the form of cost savings,
      rental payments, transmission revenues, and other fees. As part of the project,
      Tri-State provided funding to improve sulfur dioxide scrubbers, low-nitrogen
      oxide burners and other emission control upgrades for Units 1 and 2, which
      were
      completed in 2005.





Salt
      River Project
      (SRP) will purchase 100 MW of capacity from Tri-State under a 30 year power
      purchase agreement and has the right to construct and own Unit 4, a 400 MW
      coal-fired generating facility at the same Springerville site, at a later date.
      If SRP decides to construct Unit 4, TEP may be required, along with Tri-State,
      to exercise best efforts to find a replacement purchaser for SRP to purchase
      100
      MW of capacity from Unit 3. If TEP and Tri-State are unable to find such a
      replacement purchaser, TEP would then purchase 100 MW of output from Unit 4,
      beginning with the commercial operation of Unit 4. Given the current high level
      of wholesale power market prices, it is unlikely that TEP would be required
      to
      find a replacement purchaser or purchase SRP’s 100 MW. Under the terms of
      existing regulatory permits, Unit 4 is required to be completed by December
      31,
      2009.




**LIQUIDITYAND
      CAPITAL
      RESOURCES**





**TEP
      CASH
      FLOWS**





TEP’s
      capital
      requirements consist primarily of capital expenditures and optional and
      mandatory redemptions of long-term debt and capital lease obligations. Cash
      flow
      from operations typically is the lowest in the first quarter and highest in
      the
      third quarter due to TEP’s summer peaking load.





**Three
                Months Ended March 31,**
            
            **2006**
            
            **2005**-Millions
                of
                Dollars-Net
                Cash
                Flows - Operating Activities
            
            $
            43
            
            $
            37Capital
                Expenditures
            
            
            (47
            )
            
            (34
            )Net
                Cash Flows
                after Capital Expenditures*
            
            
            (4
            )
            
            3Debt
                Maturities
            
            
            -
            
            
            (1
            )Retirement
                of
                Capital Lease Obligations
            
            
            (50
            )
            
            (48
            )Proceeds
                from
                Investment in SpringervilleLease
                Debt
                and Equity
            
            
            10
            
            
            8Net
                Cash
                Flows Available after Required Payments*
            
            $
            (44
            )
            $
            (38
            )





*
      We believe that Net Cash Flows after Capital Expenditures and Net Cash Flows
      Available After Required Payments, which are non-GAAP financial measures,
      provide useful information to investors as measures of liquidity and our
      ability to meet our capital requirements and mandatory redemptions of debt
      and
      capital lease obligations.




During
      2006, TEP
      expects to generate sufficient internal cash flows to fund its operating
      activities, construction expenditures, required debt maturities, and to pay
      dividends to UniSource Energy. However, TEP’s cash flows may vary due to changes
      in wholesale revenues, changes in short-term interest rates, and other factors.
      TEP currently has $35 million available under its Revolving Credit Facility
      which it may borrow if cash flows fall short of expectations or if monthly
      cash
      requirements temporarily exceed available cash balances.





**Operating
      Activities**




In
      the first three
      months of 2006, net cash flows from operating activities increased by $6 million
      compared with the same period in 2005. Net cash flows were impacted
      by:




42





2006
      included:





·
            $11
                million
                increase in cash receipts from electric retail and wholesale sales,
                net of
                fuel and purchased energy costs, due primarily to customer growth,
                the
                higher availability of excess power to sell into the wholesale market
                and
                higher wholesale power prices;





·
            $7
                million
                decrease in payments for O&M costs due to fewer coal plant outages
                compared to last year; and





·
            $12
                million
                decrease in total interest paid due to lower capital lease obligation
                balances, lower long-term debt balances and lower annual fees under
                TEP’s
                Credit Agreement that was entered into in May
                2005.





2005
      included **:**





·
            $11
                million
                of interest received from UniSource Energy related to an inter-company
                note repaid in the first quarter of
                2005.





**Investing
      Activities**





Net
      cash used for
      investing activities was $16 million higher in the first three months of 2006
      compared with the same period in 2005, due primarily to higher capital
      expenditures. TEP’s capital expenditures increased $13 million in the first
      three months of 2006 due primarily to construction costs of Luna and growth
      and
      maintenance of TEP’s electric system.




**Financing
      Activities**





Net
      cash used for
      financing activities was $10 million higher in the first three months of 2006
      compared with the same period in 2005. The following factors contributed to
      the
      increase:





2006
      included:





·
            net
                proceeds
                of $25 million from borrowings under TEP’s Revolving Credit
                Facility;





·
            $2
                million
                increase in scheduled payments made on capital lease obligations;





2005
      included:





·
            proceeds
                of
                $95 million from UniSource Energy as a repayment for an inter-company
                loan; and





·
            the
                use of
                $53 million to redeem 1941 Mortgage Bonds in March
                2005.




At
      March 31, 2006, there were $25 million in outstanding borrowings under TEP’s
      revolving credit facility. As of May 2, 2006, cash and cash equivalents
      available to TEP was approximately $31 million.





Investments in Springerville Lease Debt





**Lease
                Debt Investment Balance****Leased
                Asset**
            
            **March
                31, 2006**
            
            **December
                31, 2005**-
                In Millions
                -Springerville
                Unit 1
            
            $
            82
            
            $
            91Springerville
                Coal Handling Facilities
            
            
            64
            
            
            65Total
                Investment In Lease Debt
            
            $
            146
            
            $
            156





The
      yields on TEP’s
      investments in Springerville Lease Debt, at the date of purchase, range from
      8.9% to 12.7%.




43





TEP
      Credit
      Agreement





In
      May 2005, TEP entered into a new $401 million Credit Agreement (TEP Credit
      Agreement) to replace its previous $401 million credit agreement. The TEP Credit
      Agreement includes a $60 million revolving credit facility and a $341 million
      letter of credit facility to support $329 million of tax-exempt variable rate
      bonds. The TEP Credit Agreement expires in May 2010 and is secured by $401
      million of 1992 Mortgage Bonds. As of March 31, 2006, TEP was in compliance
      with
      the terms of the TEP Credit Agreement.





On
      January 3, 2006, TEP borrowed $50 million under its Revolving Credit Facility.
      As of May 2, 2006, TEP had $20 million outstanding under its Revolving Credit
      Facility.




Springerville
      Common Facilities Leases





In
      1985, TEP sold
      and leased back its undivided one-half ownership interest in the common
      facilities at the Springerville Generating Station. Under the terms of the
      Springerville Common Facilities Leases, TEP must arrange for refinancing or
      refunding of the secured notes underlying the leases prior to June 30, 2006
      in
      order to avoid a special event of loss. A special event of loss results in
      a
      termination of the leases and would require TEP to repurchase the facilities
      for
      approximately $125 million. TEP is currently in the process of amending the
      agreements to refinance the debt.





As
      of March 31,
      2006, the principal balance of the lease debt was $68 million. Interest is
      payable at LIBOR plus 4%. The LIBOR rate is reset every six months and the
      rate
      in effect on March 31, 2006 was 4.69%, and was 2.78% on March 31, 2005, which
      resulted in a total interest rate on the lease debt of 8.69% at March 31, 2006
      and 7.03% at March 31, 2005.




Capital
      Lease
      Obligations





At
      March 31, 2006,
      TEP had $670 million of total capital lease obligations on its balance sheet.
      The table below provides a summary of the outstanding lease
      amounts.





**Leased
                Asset**
            
            **Balance
                at**
              **March
                31, 2006**
            
            **Expiration**-
                In Millions
                -Springerville
                Unit 1
            
            $
            396
            
            
            2014Springerville
                Coal Handling Facilities
            
            
            123
            
            
            2015Springerville
                Common Facilities
            
            
            104
            
            
            2020Sundt
                Unit
                4
            
            
            46
            
            
            2011Other
                Leases
            
            
            1
            
            
            2008Total
                Capital
                Lease Obligations
            
            $
            670





Except
      for TEP’s
      13% equity interest in the Springerville Coal Handling Facilities, TEP will
      not
      own these assets at the expiration of the leases. TEP may renew the leases
      or
      purchase the leased assets at such time. The renewal and purchase options for
      Springerville Unit 1 and Sundt Unit 4 are generally for fair market value as
      determined at that time, while the purchase price option is fixed for the
      Springerville Coal Handing Facilities and Common Facilities.




**INCOME
      TAX
      MATTERS**





See *UniSource
      Energy, Liquidity and Capital Resources, Income Tax Matters, Internal Revenue
      Service Matters,* above.





**CONTRACTUAL
      OBLIGATIONS**





There
      have been no
      significant changes in TEP’s contractual obligations or other commercial
      commitments from those reported in TEP’s 2005 Annual Report on Form 10-K, other
      than:





·
            At
                March 31,
                2006, TEP has commitments to pay various home builders $2 million
                in
                builder incentives through 2007 to construct TEP Guarantee Homes
                that meet
                the highest construction and energy-efficiency standards
                available.




44




·
            TEP
                entered
                into operating leases in the first quarter 2006 for large equipment
                at
                Springerville totaling $2 million over three
                years.





**DIVIDENDS
      ON COMMON STOCK**





TEP
      can pay
      dividends if it maintains compliance with the TEP Credit Agreement and certain
      financial covenants. As of March 31, 2006, TEP was in compliance with the terms
      of the TEP Credit Agreement.





The
      ACC Holding
      Company Order, as modified by the UES Settlement Agreement, restricted the
      amount of dividends that TEP may pay to UniSource Energy. Until TEP’s ratio of
      common equity to total capitalization (excluding capital lease obligations)
      equaled 40%, TEP could not pay dividends in excess of 75% of its net income.
      As
      of March 31, 2006, TEP’s ratio of common equity to total capitalization
      (excluding capital lease obligations) was 41.1%.





The
      Federal Power
      Act states that dividends shall not be paid out of funds properly included
      in
      capital accounts. Although the terms of the Federal Power Act are unclear,
      we
      believe that there is a reasonable basis to pay dividends from current year
      earnings.




**UNSGAS**





**RESULTSOF
      OPERATIONS**




**Three
      Months Ended March 31, 2006 Compared with the Three Months Ended March 31,
      2005**





UNS
      Gas reported
      net income of $5 million in the first quarter of 2006 and $4 million in the
      first quarter of 2005.





As
      of March 31,
      2006, UNS Gas had approximately 142,000 retail customers, a 4% increase from
      last year. The table below shows UNS Gas’ therm sales and revenues for the first
      quarters of 2006 and 2005.





**Sales**
            
            **Revenue****Three
                Months Ended March 31,**
            
            **2006**
            
            **2005**
            
            **2006**
            
            **2005**-
                Millions of
                Therms -
            
            -
                Millions of
                Dollars -**Retail
                Therm Sales:**Residential
            
            
            31
            
            
            30
            
            $
            40
            
            $
            30Commercial
            
            
            11
            
            
            10
            
            
            13
            
            
            9Industrial
            
            
            1
            
            
            1
            
            
            1
            
            
            1Public
                Authorities
            
            
            3
            
            
            3
            
            
            4
            
            
            2**Total
                Retail Therm Sales**
            
            
            46
            
            
            44
            
            
            58
            
            
            42Transport
            
            
            -
            
            
            -
            
            
            1
            
            
            1Negotiated Sales Program (NSP)
            
            
            5
            
            
            5
            
            
            4
            
            
            3**Total
                Therm Sales**
            
            
            51
            
            
            49
            
            $
            63
            
            $
            46




Retail
      therm sales
      were 5% higher in the first quarter of 2006 compared with the same period last
      year, due primarily to customer growth. Retail revenues were higher by 38%
      due
      primarily to the PGA surcharge increase, which became effective in November
      2005. See *Factors
      Affecting Results of Operations, Rates and Regulation, Energy Cost Adjustment
      Mechanism,* below.





Through
      a
      Negotiated Sales Program (NSP) approved by the ACC, UNS Gas supplies natural
      gas
      to some of its large transportation customers. Approximately one half of the
      margin earned on these NSP sales is retained by UNS Gas, while the remainder
      benefits retail customers through a credit to the PGA mechanism which reduces
      the gas commodity price. See *Factors
      Affecting Results of Operations, Rates and Regulation, Energy Cost Adjustment
      Mechanism,* below.




45




The
      table below
      provides summary financial information for UNS Gas.





**Three
                Months Ended March 31,**
            
            **2006**
            
            **2005**-
                Millions of
                Dollars -Gas
                Revenues
            
            $
            63
            
            $
            46Other
                Revenues
            
            
            -
            
            
            1Total Operating Revenues
            
            
            63
            
            
            47Purchased
                Gas
                Expense
            
            
            46
            
            
            31Other
                Operations and Maintenance Expense
            
            
            6
            
            
            6Depreciation
                and Amortization
            
            
            1
            
            
            1Taxes
                other
                than Income Taxes
            
            
            1
            
            
            1Total Other Operating Expenses
            
            
            54
            
            
            39Operating
                Income
            
            
            9
            
            
            8Total
                Interest Expense
            
            
            1
            
            
            1Income
                Tax
                Expense (Benefit)
            
            
            3
            
            
            3**Net
                Income**
            
            $
            5
            
            $
            4


**FACTORSAFFECTING
      RESULTS OF OPERATIONS**





**RATES
      AND
      REGULATION**





When
      ACC-designated
      under or over recovery trigger points are met, UNS Gas may request a PGA
      surcharge or credit to collect or return the amount deferred from or to
      customers. *See
      Energy Cost
      Adjustment Mechanism,* below.





**Energy
      Cost
      Adjustment Mechanism**





UNS
      Gas’ retail
      rates include a PGA mechanism intended to address the volatility of natural
      gas
      prices and allow UNS Gas to recover its actual commodity costs, including
      transportation, through a price adjustor. The difference between UNS Gas’ actual
      gas and transportation costs and the cost of gas and transportation recovered
      through base rates are deferred and recovered or repaid through the PGA
      mechanism.





The
      PGA mechanism
      has two components, the PGA factor and the PGA surcharge or credit. The PGA
      factor is a mechanism that compares the twelve-month rolling weighted average
      gas cost to the base cost of gas, and automatically adjusts monthly, subject
      to
      limitations on how much the price per therm may change in a twelve month period.
      The actual gas and transportation costs that are either under or over collected
      through the PGA factor
      are charged
      or credited to a balancing account (PGA bank).





The
      current annual
      cap on the maximum increase in the PGA factor is $0.10. In January 2006, UNS
      Gas
      filed a request with the ACC to increase the cap to $0.20 to allow for more
      timely recovery of actual gas costs. We cannot predict when the ACC will take
      action on this matter.





When
      ACC-designated
      under or over recovery trigger points of $6.2 million and $4.5 million,
      respectively, are met, UNS Gas may request a PGA surcharge or credit with the
      goal of collecting or returning the amount deferred from or to customers over
      a
      period deemed appropriate by the ACC.




46





In
      October 2005, the ACC approved the following PGA surcharges:





**Surcharge
                Amount**
              **Per
                Therm**
            **Period
                In Effect**$0.15
            November
                2005
                - February 2006$0.25
            March
                2006 -
                April 2006$0.30
            May
                2006 -
                June 2006$0.35
            July
                2006 -
                September 2006$0.25
            October
                2006
                - November 2006$0.20
            December
                2006
                - February 2007$0.25
            March
                2007 -
                April 2007





Currently,
      this PGA
      surcharge is expected to allow UNS Gas to fully collect the PGA bank balance
      in
      a timely manner. However, if gas prices increase, the PGA bank balance may
      continue to grow despite this surcharge. Changes in the market price for gas,
      sales volumes and surcharge changes could significantly change the PGA bank
      balance in the future. The PGA bank balance was $1 million at March 31,
      2006.




**General
      Rate Case Filing**





UNS
      Gas expects to
      file a general rate case in July 2006.





**LIQUIDITYAND
      CAPITAL
      RESOURCES**





UNS
      Gas’ capital
      requirements consist primarily of capital expenditures. In the first three
      months of 2006, capital expenditures were $6 million. During 2006, UNS Gas
      expects operating cash flows to fund a portion of its construction expenditures.
      UNS Gas will meet its remaining cash needs through a combination of existing
      cash, capital contributions from UniSource Energy and borrowings under the
      revolving credit facility.





The
      table below
      provides summary information for operating cash flow and capital expenditures
      for the first three months of 2006 and 2005.





**Three
                Months Ended March 31,**
            
            **2006**
            
            **2005**-
                Millions of
                Dollars -Net
                Cash
                Flows - Operating Activities
            
            $
            7
            
            $
            6Capital
                Expenditures
            
            
            6
            
            
            7





UNS
      Gas/UNS
      Electric Revolver





In
      April 2005, UNS Gas and UNS Electric entered into a $40 million three-year
      unsecured revolving credit agreement due in April 2008, with a group of lenders
      (the UNS Gas/UNS Electric Revolver). Either borrower may borrow up to a maximum
      of $30 million; however, the total combined amount borrowed cannot exceed $40
      million. UNS Gas and UNS Electric intend to use the proceeds of any loans or
      letters of credit for general corporate purposes.




UNS
      Gas expects to
      draw upon the UNS Gas/UNS Electric Revolver from time to time for seasonal
      working capital purposes and to fund a portion of capital expenditures. As
      of
      March 31, 2006, UNS Gas had no borrowings outstanding under the UNS Gas/UNS
      Electric Revolver.





Senior
      Unsecured
      Notes





UNS
      gas has $100
      million of senior unsecured notes that are guaranteed by UES. The note purchase
      agreement for UNS Gas restricts transactions with affiliates, mergers, liens,
      restricted payments and incurrence of indebtedness, and also contains a minimum
      net worth test. As of March 31, 2006, UNS Gas was in compliance with the terms
      of its note purchase agreement.




UNS
      Gas must meet a
      leverage test and an interest coverage test to issue additional debt or to
      pay
      dividends. However, UNS Gas may, without meeting these tests, refinance existing
      debt and incur up to $7 million in short-term debt.





47





**INCOME
      TAX
      MATTERS**




See *UniSource
      Energy, Liquidity and Capital Resources, Income Tax Matters, Internal Revenue
      Service Matters,* above.




**DIVIDENDS
      ON COMMON STOCK**




ACC
      limits dividend
      payments by UNS Gas to 75% of earnings, until the ratio of UNS Gas’ common
      equity to total capitalization reaches 40%. At March 31, 2006, the ratio of
      common equity to total capitalization for UNS Gas was 45.8%.




The
      note purchase
      agreement for UNS Gas contains restrictions on dividends. UNS Gas may pay
      dividends so long as (a) no default or event of default exists and (b) it could
      incur additional debt under the debt incurrence test. See *Senior
      Unsecured Notes* ,
      above. It is
      unlikely, however, that UNS Gas will pay dividends in the next few years due
      to
      expected cash requirements for capital expenditures.




**UNSELECTRIC**





**RESULTSOF
      OPERATIONS**





**Three
      Months Ended March 31, 2006 Compared with the Three Months Ended March 31,
      2005**




UNS
      Electric
      reported net income of $1 million in the first quarters of 2006 and 2005.
      Similar to TEP’s operations, we expect UNS Electric’s operations to be seasonal
      in nature, with peak energy demand occurring in the summer months.




As
      of March 31, 2006, UNS Electric had approximately 91,000 retail customers,
      a
      4.8% increase from last year. The table below shows UNS Electric’s kWh sales and
      revenues for the first quarters of 2006 and 2005.


**Sales**
              
              **Revenue****Three
                  Months Ended March 31,**
              
              
              **2006**
              
              
              **2005**
              
              
              **2006**
              
              
              **2005**-
                  Millions of
                  kWh -
              -
                  Millions of Dollars -**Electric
                  Retail Sales:**Residential
              
              
              163
              
              
              152
              
              $
              17
              
              $
              16Commercial
              
              
              130
              
              
              122
              
              
              13
              
              
              12Industrial
              
              
              46
              
              
              42
              
              
              4
              
              
              3Other
              
              
              1
              
              
              1
              
              
              -
              
              
              -**Total
                  Electric Retail Sales**
              
              
              340
              
              
              317
              
              $
              34
              
              $
              31




Retail
      kWh sales
      were 7% higher in the first quarter of 2006 compared with the same period last
      year due primarily to customer growth.




48




The
      table below
      provides summary financial information for UNS Electric.





**Three
                Months Ended March 31,**
            
            **2006**
            
            **2005**-
                Millions of
                Dollars -Electric
                Revenues
            
            $
            34
            
            $
            31Other
                Revenues
            
            
            -
            
            
            1Total Operating Revenues
            
            
            34
            
            
            32Purchased
                Energy Expense
            
            
            22
            
            
            21Other
                Operations and Maintenance Expense
            
            
            6
            
            
            6Depreciation
                and Amortization
            
            
            3
            
            
            2Taxes
                other
                than Income Taxes
            
            
            1
            
            
            1Total Other Operating Expenses
            
            
            32
            
            
            30Operating
                Income
            
            
            2
            
            
            2Total
                Interest Expense
            
            
            1
            
            
            1Income
                Tax
                Expense
            
            
            -
            
            
            -**Net
                Income**
            
            $
            1
            
            $
            1




**FACTORSAFFECTING
      RESULTS OF
      OPERATIONS**





**COMPETITION**





As
      required by the
      ACC order approving UniSource Energy’s acquisition of the Citizens’ Arizona gas
      and electric assets, in 2003, UNS Electric filed with the ACC a plan to open
      its
      service territories to retail competition by December 31, 2003. The plan
      addressed all aspects of implementation. It included UNS Electric’s unbundled
      distribution tariffs for both standard offer customers and customers that choose
      competitive retail access, as well as Direct Access and Settlement Fee
      schedules. UNS Electric’s direct access rates for both transmission and
      ancillary services would be based upon its FERC Open Access Transmission Tariff.
      The plan is subject to review and approval by the ACC, which has not yet
      considered the plan. As a result of the court decisions concerning the ACC’s
      Retail Electric Competition Rules, we are unable to predict when and how the
      ACC
      will address this plan. See *Tucson
      Electric
      Power Company, Factors Affecting Results of Operations,
      Competition,* above for
      information regarding the Arizona Court of Appeals decision.





**RATES
      AND
      REGULATION**





**Energy
      Cost
      Adjustment Mechanism**





UNS
      Electric’s
      retail rates include a PPFAC, which allows for a separate surcharge or surcredit
      to the base rate for delivered purchased power to collect or return under or
      over recovery of costs. The ACC has approved a PPFAC surcharge of $0.01825
      per
      kWh to recover transmission costs and the cost of the current full-requirements
      power supply agreement with PWCC.





**General
      Rate Case Filing**





UNS
      Electric
      expects to file a general rate case in the second half of 2006.





**LIQUIDITYAND
      CAPITAL
      RESOURCES**





UNS
      Electric’s
      capital requirements consist of capital expenditures, which were $10 million
      in
      the first three months of 2006.





To
      improve the reliability of service in Santa Cruz County, UNS Electric is
      building a 20 MW gas-fired combustion turbine at the Valencia site, and plans
      to
      upgrade its existing 115 kV line over time. The turbine should be in place
      by
      mid-2006. In the first quarter of 2006, UNS Electric’s capital expenditures
      included $3 million related to the turbine and expects its capital expenditures
      for the remainder of 2006 to include approximately $1 million related to this
      project.




49




During
      2006, UNS
      Electric expects to generate sufficient operating cash flows to fund a portion
      of its construction expenditures. UNS Electric will meet its remaining cash
      needs through a combination of capital contributions from UniSource Energy
      and
      borrowings under the revolving credit facility.





The
      table below
      provides summary information for operating cash flow and capital expenditures
      for the first three months of 2006 and 2005.





**Three
                Months Ended March 31,**
            
            **2006**
            
            **2005**-
                Millions of
                Dollars -Net
                Cash
                Flows - Operating Activities
            
            $
            4
            
            $
            7Capital
                Expenditures
            
            
            10
            
            
            5





UNS
      Gas/UNS
      Electric Revolver





See *UNS
      Gas,
      Liquidity and Capital Resources, UNS Gas/UNS Electric Revolver* above for
      description of UNS Electric’s unsecured revolving credit agreement.





UNS
      Electric
      expects to draw upon the UNS Gas/UNS Electric Revolver from time to time for
      seasonal working capital purposes and to fund a portion of its capital
      expenditures. As of March 31, 2006, UNS Electric had $12 million outstanding
      under the UNS Gas/UNS Electric Revolver. At May 2, 2006, UNS Electric had $12
      million outstanding under the UNS Gas/UNS Electric Revolver.





Senior
      Unsecured
      Notes





UNS
      Electric has
      $60 million of 7.61% senior unsecured notes outstanding due in 2008 that are
      guaranteed by UES. The note purchase agreements for UNS Electric contain certain
      restrictive covenants, including restrictions on transactions with affiliates,
      mergers, liens to secure indebtedness, restricted payments, incurrence of
      indebtedness, and minimum net worth. As of March 31, 2006, UNS Electric was in
      compliance with the terms of its note purchase agreement.





UNS
      Electric must
      meet a leverage test and an interest coverage test to issue additional debt
      or
      to pay dividends. However, UNS Electric may, without meeting these tests,
      refinance existing debt and incur up to $5 million in short-term
      debt.





**INCOME
      TAX
      MATTERS**





See *UniSource
      Energy, Liquidity and Capital Resources, Income Tax Matters, Internal Revenue
      Service Matters,* above.


**DIVIDENDS** **ON
        COMMON
        STOCK**




The ACC limits dividend payments by UNS Electric to 75% of earnings, until
      the
      ratio of common equity to total capitalization reaches 40%. At March 31, 2006,
      the ratio of common equity to total capitalization for UNS Electric was 45.6%.




The note purchase agreement for UNS Electric contains restrictions on dividends.
      UNS Electric may pay dividends so long as (a) no default or event of default
      exists and (b) it could incur additional debt under the debt incurrence test.
      See *Senior
      Unsecured Notes* ,
      above. It is
      unlikely, however, that UNS Electric will pay dividends in the next few years
      due to expected cash requirements for capital expenditures.




50





**OTHER**





**RESULTSOF
      OPERATIONS**





The
      table below
      summarizes the income and losses for the Other non-reportable
      segments:





**Three
                Months Ended March 31,**
            
            **2006**
            
            **2005**-
                Millions of
                Dollars -Millennium
                Investments
            
            $
            (1
            )
            $
            (1
            )UniSource
                Energy Parent Company
            
            
            (2
            )
            
            (1
            )Total
                Other
            
            $
            (3
            )
            $
            (2
            )







**UniSource
      Energy Parent Company**





In
      2006 and 2005, UniSource Energy parent company expenses include interest expense
      (net of tax) related to the UniSource Energy Convertible Senior Notes, the
      UniSource Credit Agreement and, in the first three months of 2005, a note
      payable from UniSource Energy to TEP, which was repaid in March 2005.





**Millennium
      Investments**





Millennium
      accounts
      for its investments under the consolidation method and the equity method. In
      some cases, Millennium is an investment’s sole provider of funding. When this is
      the case, Millennium recognizes 100% of an investment’s losses, because as sole
      provider of funds it bears all of the financial risk. To the extent that an
      investment becomes profitable and Millennium has recognized losses in excess
      of
      its percentage ownership, Millennium will recognize 100% of an investment’s net
      income until Millennium’s recognized losses equal its ownership percentage of
      losses.





Millennium
      Investments, excluding the discontinued operations of Global Solar, recorded
      after-tax losses of less than $1 million in the first quarter of 2006. In the
      first three months of 2005, results include after-tax losses of less than $1
      million each from several of Millennium’s investments.




**FACTORS
      AFFECTING RESULTS OF OPERATIONS**





**Millennium
      Investments**





On
      March 31, 2006, Millennium sold Global Solar for $16 million in cash. In
      addition, Millennium received an option to purchase, under certain conditions,
      5% to 10% of Global Solar at a future date. The option is exercisable, upon
      the
      occurrence of certain events, beginning in April 2013 and expires in April
      2016.
      In the first quarter of 2006, UniSource Energy recorded an after-tax loss of
      approximately $3 million related to the discontinued operations and disposal
      of
      Global Solar.





In
      January 2006, Millennium sold its equity investment in MicroSat, which was
      written down in December 2005 to the value at which it was sold.





In
      2005, Millennium
      restructured its investment in IPS which included the formation of a new entity
      and a reduction in the percentage of equity held by Millennium to 31.4%.
      Millennium also committed to fund up to $3 million towards a future IPS
      investment offering, of which $2 million has already been funded as a secured
      loan to be converted to shares of IPS stock at the close of the offering.





MEG’s
      activities
      consist of managing a small number of remaining positions, including a hedge,
      which are expected to close by early 2008. As of March 31, 2006, the fair value
      of MEG’s trading assets was $15 million and the fair value of MEG’s trading
      liabilities was $5 million.





Millennium
      is in
      the process of selling its remaining interest in Nations Energy Corporation.




**LIQUIDITY
      AND CAPITAL RESOURCES**




Millennium’s
      remaining commitments are $2 million to Haddington, $2 million to Valley
      Ventures and $1 million to IPS.




51





Millennium
      expects to
      receive the remaining payment of $5 million on a note receivable from a
      subsidiary of Mirant Corporation in July 2006.





UniSource
      Energy
      has ceased making loans or equity contributions to Millennium. We anticipate
      that the funding required to fund Millennium’s remaining commitments will be
      provided only out of existing Millennium cash or cash returns from Millennium
      investments. We believe such cash and returns will be adequate to fund
      Millennium’s remaining commitments.




**CRITICALACCOUNTING
      ESTIMATES**





In
      preparing
      financial statements under Generally Accepted Accounting Principles (GAAP),
      management exercises judgment in the selection and application of accounting
      principles, including making estimates and assumptions. UniSource Energy and
      TEP
      consider Critical Accounting Estimates to be those that could result in
      materially different financial statement results if our assumptions regarding
      application of accounting principles were different. UniSource Energy and TEP
      describe their Critical Accounting Estimates below. Other significant accounting
      policies and recently issued accounting standards are discussed in the *2005
      Annual
      Report on Form 10-K, Note 1 of Notes to Consolidated Financial Statements -
      Nature of Operations and Summary of Significant Accounting
      Estimates.*





**ACCOUNTING
      FOR RATE REGULATION**





TEP,
      UNS Gas and
      UNS Electric generally use the same accounting policies and practices used
      by
      unregulated companies for financial reporting under GAAP. However, sometimes
      these principles, such as the Financial Accounting Standards Board’s (FASB)
      Statement of Financial Accounting Standards No. 71, *Accounting
      for
      the Effects of Certain Types of Regulation* (FAS 71), require
      special accounting treatment for regulated companies to show the effect of
      regulation. For example, in setting TEP, UNS Gas and UNS Electric’s retail
      rates, the ACC may not allow TEP, UNS Gas or UNS Electric to currently charge
      their customers to recover certain expenses, but instead may require that these
      expenses be charged to customers in the future. In this situation, FAS 71
      requires that TEP, UNS Gas and UNS Electric defer these items and show them
      as
      regulatory assets on the balance sheet until TEP, UNS Gas and UNS Electric
      are
      allowed to charge their customers. TEP, UNS Gas and UNS Electric then amortize
      these items as expense to the income statement as these charges are recovered
      from customers. Similarly, certain revenue items may be deferred as regulatory
      liabilities, which are also eventually amortized to the income statement as
      rates to customers are reduced.





The
      conditions a
      regulated company must satisfy to apply the accounting policies and practices
      of
      FAS 71 include:




·
            an
                independent regulator sets rates;


·
            the
                regulator
                sets the rates to recover specific costs of delivering service;
                and


·
            the
                service
                territory lacks competitive pressures to reduce rates below the rates
                set
                by the regulator.





**TEP**





Upon
      approval by
      the ACC of a settlement agreement (Settlement Agreement) in November 1999,
      TEP
      discontinued application of FAS 71 for its generation operations. TEP continues
      to apply FAS 71 to its cost-based rate regulated operations, which include
      the
      transmission and distribution portions of its business.





TEP’s
      transmission
      and distribution regulatory assets, net of regulatory liabilities, totaled
      $148
      million at March 31, 2006. Regulatory assets of $30 million are not presently
      included in the rate base and consequently are not earning a return on
      investment. These regulatory assets are being recovered through the cost of
      service or are authorized to be collected in future base rates. TEP’s
      transmission and distribution regulatory assets, net of regulatory liabilities,
      totaled $163 million at December 31, 2005.





TEP
      regularly
      assesses whether it can continue to apply FAS 71 to its cost-based rate
      regulated operations. If TEP stopped applying FAS 71 to its remaining regulated
      operations, it would write off the related balances of its regulatory assets
      as
      an expense and its regulatory liabilities as income on its income statement.
      Based on the regulatory asset balances, net of regulatory liabilities, at March
      31, 2006, if TEP had stopped applying
      FAS 71 to
      its remaining regulated operations, it would have recorded an extraordinary
      after-tax loss of approximately $90 million. While regulatory orders and market
      conditions may affect cash flows, TEP’s cash flows would not be affected if it
      stopped applying FAS 71.




52





**UNS
      Gas and
      UNS Electric**





UNS
      Gas and UNS
      Electric’s regulatory liabilities, net of regulatory assets, collectively
      totaled $9 million at March 31, 2006 and at $4 million at December 31, 2005.
      UNS
      Electric has $7 million of regulatory liabilities that are not included in
      rate
      base. UNS Gas and UNS Electric regularly assess whether they can continue to
      apply FAS 71 to their cost-based rate regulated operations. If UNS Gas and
      UNS
      Electric stopped applying FAS 71 to their regulated operations, they would
      write
      off the related balances of regulatory assets as an expense and regulatory
      liabilities as income on their income statements. Based on the balances of
      regulatory liabilities and assets at March 31, 2006, if UNS Gas and UNS Electric
      had stopped applying FAS 71 to their regulated operations, UNS Gas would record
      an extraordinary after-tax gain of $1 million and UNS Electric would record
      an
      extraordinary after-tax gain of $5 million. UNS Gas and UNS Electric’s cash
      flows would not be affected if they stopped applying FAS 71.





**ACCOUNTING
      FOR ASSET RETIREMENT OBLIGATIONS**




FAS
      143, issued by
      the FASB, requires entities to record the fair value of a liability for a legal
      obligation to retire an asset in the period in which the liability is incurred.
      A legal obligation is a liability that a party is required to settle as a result
      of an existing or enacted law, statute, ordinance or contract. A legal
      obligation can also be associated with the retirement of a long-lived asset
      whose timing and/or method of settlement are conditional on a future event.
      We
      are required to record a conditional asset retirement obligation at its
      estimated fair value if that fair value can be reasonably estimated. When the
      liability is initially recorded, the entity should capitalize a cost by
      increasing the carrying amount of the related long-lived asset. Over time,
      the
      liability is adjusted to its present value by recognizing accretion expense
      as
      an operating expense in the income statement each period, and the capitalized
      cost is depreciated over the useful life of the related asset. Upon settlement
      of the liability, an entity either settles the obligation for its recorded
      amount or incurs a gain or loss if the actual costs differ from the recorded
      amount.





**TEP**





In
      2005, TEP
      implemented FIN 47. The implementation of FIN 47 required TEP to update an
      existing inventory, originally created for the implementation of FAS 143, and
      to
      determine which, if any, of the conditional asset retirement obligations could
      be reasonably estimated. The ability to
      reasonably estimate conditional asset retirement obligations was a matter of
      management judgment, based upon management’s ability to estimate a settlement
      date or range of settlement dates, a method or potential method of settlement
      and probabilities associated with the potential dates and methods of settlement
      of TEP’s conditional asset retirement obligations. In determining whether its
      conditional asset retirement obligations could be reasonably estimated,
      management considered TEP’s past practices, industry practices, management’s
      intent and the estimated economic life of the assets. The fair value of the
      conditional asset retirement obligations were then estimated using an expected
      present value technique. Changes in management’s assumptions regarding
      settlement dates, settlement methods or assigned probabilities could have a
      material effect on the liability recorded by TEP at March 31, 2006 as well
      as
      the associated cumulative effect of the change in accounting principle recorded.
      The liabilities associated with conditional asset retirement obligations will
      be
      adjusted on an ongoing basis due to the passage of time and revisions to either
      the timing or amount of the original estimates of undiscounted cash flows.
      These
      adjustments could have a significant impact on the Consolidated Balance Sheets
      and Consolidated Statements of Income.





Prior
      to
      implementing FAS 143, costs for final removal of all owned generation facilities
      were accrued as an additional component of depreciation expense. Under FAS
      143,
      only the costs to remove an asset with legally binding retirement obligations
      will be accrued over time through accretion of the asset retirement obligation
      and depreciation of the capitalized asset retirement cost. As of March 31,
      2006,
      TEP had a liability of $4 million associated with its final asset retirement
      obligations.





TEP
      has identified
      legal obligations to retire generation plant assets specified in land leases
      for
      its jointly-owned Navajo and Four Corners Generating Stations. The land on
      which
      these stations reside is leased from the Navajo Nation. The provisions of the
      leases require the lessees to remove the facilities upon request of the Navajo
      Nation at the expiration of the leases. TEP also has certain environmental
      obligations at the San Juan Generating Station. In addition, TEP has obligations
      for its share of Luna to remove certain piping and evaporation ponds
      and to
      restore the ground to its original condition. TEP has estimated that its share
      of the cost to remove the Navajo and Four Corners facilities, to settle the
      San
      Juan environmental obligations and its share of costs at Luna will be
      approximately $40 million at the date of retirement. No other legal obligations
      to retire generation plant assets were identified.




53





TEP
      has various
      transmission and distribution lines that operate under land leases and rights
      of
      way that contain end dates and restorative clauses. TEP operates its
      transmission and distribution lines as if they will be operated in perpetuity
      and would continue to be used or sold without land remediation. As a result,
      TEP
      is not recognizing the costs of final removal of the transmission and
      distribution lines in the financial statements.





For
      the net cost of
      removal for the interim retirements from its transmission, distribution and
      general plant, as of March 31, 2006, TEP had accrued $76 million. As of December
      31, 2005, TEP had accrued $75 million for the net cost of removal for interim
      retirements. The amount is recorded as a regulatory liability.




Amounts
      recorded
      under FAS 143 are subject to various assumptions and determinations, such as
      determining whether a legal obligation exists to remove assets, estimating
      the
      fair value of the costs of removal, estimating when final removal will occur,
      and the credit-adjusted risk-free interest rates to be used to discount future
      liabilities. Changes that may arise over time with regard to these assumptions
      and determinations will change amounts recorded in the future as expense for
      asset retirement obligations.





If
      TEP retires any
      asset at the end of its useful life, without a legal obligation to do so, it
      will record retirement costs at that time as incurred or accrued. TEP does
      not
      believe that the implementation of FAS 143 will result in any change in retail
      rates since all matters relating to the rate-making treatment of TEP’s
      generating assets have been determined pursuant to the Settlement Agreement.
      See *Tucson
      Electric Power Company, Factors Affecting Results of Operations, Rates,
      Settlement Agreement,* above *.*





**UES**





UES
      has various
      transmission and distribution lines that operate under land leases and rights
      of
      way that contain end dates and restorative clauses. UES operates its
      transmission and distribution lines as if they will be operated in perpetuity
      and would continue to be used or sold without land remediation. As a result,
      UES
      is not recognizing the cost of final removal of the transmission and
      distribution lines in the financial statements.





For
      the net cost of
      removal for interim retirements from its transmission, distribution and general
      plant, UES had accrued $4 million as of March 31, 2006 and as of December 31,
      2005. The amount is recorded as a regulatory liability.




**PENSION
      AND
      OTHER POST RETIREMENT BENEFIT PLAN ASSUMPTIONS**





We
      record plan
      assets, obligations, and expenses related to pension and other postretirement
      benefit plans based on actuarial valuations. These valuations include key
      assumptions on discount rates, expected returns on plan assets, compensation
      increases and health care cost trend rates. These actuarial assumptions are
      reviewed annually and modified as appropriate. The effect of modifications
      is
      generally recorded or amortized over future periods. We believe that the
      assumptions used in recording obligations under the plans are reasonable based
      on prior experience, market conditions and the advice of plan
      actuaries.





**TEP**





TEP
      discounted its
      future pension plan obligations at December 31, 2005 using a rate of 5.8% for
      its Salaried, Union Plans and Excess Benefit Plan. The discount rate used at
      December 31, 2004 was 6.1% for its Salaried and Union Plans and 6.0% for its
      Excess Benefit Plan. TEP discounted its other postretirement plan obligations
      using a rate of 5.8% at December 31, 2005, compared with 5.9% at December 31,
      2004. TEP determines the discount rate annually based on the rates currently
      available on high-quality, non-callable, long-term bonds. TEP looks to bonds
      that receive one of the two highest ratings given by a recognized rating agency
      whose future cash flows match the timing and amount of expected future benefit
      payments.





The
      pension
      liability and future pension expense both increase as the discount rate is
      reduced. A decrease in the discount rate results in an increase in the Projected
      Benefit Obligation (PBO) and the service cost component of pension expense.
      Additionally, the recognized actuarial loss is significantly impacted by a
      reduction in the discount rate. Since the PBO increases with the decrease in
      discount rate, the obligation is that much larger than
      would normally
      occur due to normal growth of the plan. This leads to an actuarial loss (or
      a
      greater actuarial loss than would occur in the absence of the discount rate
      change), which is amortized over future periods leading to a greater expense.
      The resulting change in the interest cost component of pension expense is
      dependent on the effect that the change in the discount rate has on the PBO
      and
      will vary based on employee demographics. The effect of the lower rate used
      to
      calculate the interest cost is offset to some degree by a larger obligation.
      The
      relative magnitude of these two changes determines whether interest cost will
      increase or decrease. For TEP’s




54




pension
      plans, a 25
      basis point decrease in the discount rate would increase the accumulated benefit
      obligation (ABO) by approximately $6 million and the related plan expense for
      2006 by approximately $1 million. A similar increase in the discount rate would
      decrease the ABO by approximately $6 million and the related plan expense for
      2006 by approximately $1 million. For TEP’s plan for other postretirement
      benefits, a 25 basis point change in the discount rate would increase or
      decrease the accumulated postretirement benefit obligation (APBO) by
      approximately $2 million. A 25 basis point change in the discount rate would
      not
      have a significant impact on the related plan expense for 2006.





TEP
      calculates the
      market-related value of plan assets using the fair value of plan assets on
      the
      measurement date. TEP assumed that its plans’ assets would generate a long-term
      rate of return of 8.25% at December 31, 2005 and 8.5% at December 31, 2004.
      In
      establishing its assumption as to the expected return on plan assets, TEP
      reviews the plans’ asset allocation and develops return assumptions for each
      asset class based on advice from an investment consultant and the plans’ actuary
      that includes both historical performance analysis and forward looking views
      of
      the financial markets. Pension expense increases as the expected rate of return
      on plan assets decreases. A 25 basis point change in the expected return on
      plan
      assets would not have a significant impact on pension expense for
      2006.





TEP
      used an initial
      health care cost trend rate of 10.0% in valuing its postretirement benefit
      obligation at December 31, 2005. This rate reflects both market conditions
      and
      the plan’s experience. Assumed health care cost trend rates have a significant
      effect on the amounts reported for health care plans. A 1% increase in assumed
      health care cost trend rates would increase the postretirement benefit
      obligation by approximately $5 million and the related plan expense by
      approximately $1 million. A similar decrease in assumed health care cost trend
      rates would decrease the postretirement benefit obligation by approximately
      $4
      million and the related plan expense by less than $1 million.





TEP
      recorded a
      minimum pension liability in Other Comprehensive Income of approximately $24
      million at December 31, 2005, compared with $20 million at December 31, 2004.
      This increase resulted primarily from a reduction in the assumed discount
      rate.





Based
      on the above
      assumptions, TEP will record pension expense of approximately $10 million and
      other postretirement benefit expense of $6 million ratably throughout 2006.
      TEP
      will make required pension plan contributions of $8 million in 2006. TEP’s other
      postretirement benefit plan is not funded. TEP expects to make benefit payments
      to retirees under the postretirement benefit plan of approximately $3 million
      in
      2006.





**UES**





Concurrent
      with the
      acquisition of the Arizona gas and electric system assets from Citizens on
      August 11, 2003, UES established a pension plan for substantially all of its
      employees. UES did not assume the pension obligation for employees’ years of
      service with Citizens.





UES
      discounted its
      future pension plan obligations using a rate of 5.9% at December 31, 2005 and
      6.1% at December 31, 2004. For UES’ pension plan, a 25 basis point change in the
      discount rate would have minimal effect on either the ABO or the related pension
      expense. UES did not record a minimum pension liability or offsetting Intangible
      Asset at December 31, 2005. At December 31, 2004, UES recorded a minimum pension
      liability and offsetting Intangible Asset of less than $1 million. UES will
      record pension expense of $1 million in 2006. UES will make a pension plan
      contribution of $1 million in 2006.





On
      the acquisition
      date, UES assumed the obligation to provide postretirement benefits for a small
      population of former Citizens employees, both active and retired. The plan
      is
      not funded. UES discounted its other postretirement plan obligations using
      a
      rate of 5.8% at December 31, 2005, compared with 5.9% at December 31, 2004.
      Postretirement medical benefit expenses are insignificant to UES’
operations.





**ACCOUNTING
      FOR DERIVATIVE INSTRUMENTS, TRADING ACTIVITIES AND HEDGING
      ACTIVITIES**




A
      derivative
      financial instrument or other contract derives its value from another investment
      or designated benchmark. TEP enters into forward contracts to purchase or sell
      a
      specified amount of capacity or energy at a specified price over a given period
      of time, typically for one month, three months, or one year, within established
      limits to take advantage of favorable market opportunities. In general, TEP
      enters into forward purchase contracts when market conditions provide the
      opportunity to purchase energy for its load at prices that are below the
      marginal cost of its supply resources or to supplement its own resources (e.g.,
      during plant outages and summer peaking periods). TEP enters into forward sales
      contracts when it forecasts that it has excess supply and the




55




market
      price of
      energy exceeds its marginal cost. A portion of TEP’s forward contracts are
      considered to be normal purchases and sales and, therefore, are not required
      to
      be marked to market. However, some of these forward contracts are considered
      to
      be derivatives, which TEP marks to market by recording unrealized gains and
      losses and adjusting the related assets and liabilities on a monthly basis
      to
      reflect the market prices at the end of the month. Some of these forward
      contracts satisfy the requirements for cash flow hedge accounting and the
      unrealized gains and losses are recorded in Other Comprehensive Income, a
      component of Common Stock Equity, rather than being reflected in the income
      statement.





TEP
      has a natural
      gas supply agreement under which it purchases all of its gas requirements at
      spot market prices from Southwest Gas Corporation (SWG). TEP also has agreements
      to purchase power that are priced using spot market gas prices. These contracts
      meet the definition of normal purchases and are not required to be marked to
      market. During 2004 and early 2005, in an effort to minimize price risk on
      these
      purchases, TEP entered into commodity price swap agreements under which TEP
      purchases gas at fixed prices and simultaneously sells gas at spot market
      prices. The spot market price in the swap agreements is tied to the same index
      as the purchases under the SWG and purchased power contracts. These swap
      agreements, which expire during the summer months through 2008, were entered
      into with the goal of locking in fixed prices on at least 45% and not more
      than
      80% of TEP’s expected summer monthly gas risk prior to entering into the month.
      The swap agreements are marked to market on a monthly basis; however, since
      the
      agreements satisfy the requirements for cash flow hedge accounting, the
      unrealized gains and losses are recorded in Other Comprehensive Income rather
      than being reflected in the income statement. As the gains and losses on these
      cash flow hedges are realized, a reclassification adjustment is recorded in
      Other Comprehensive Income for realized gains and losses that are included
      in
      Net Income.





TEP
      manages the
      risk of counterparty default by performing financial credit reviews, setting
      limits, monitoring exposures, requiring collateral when needed, and using a
      standardized agreement which allows for the netting of current period exposures
      to and from a single counterparty.





UNS
      Gas and UNS
      Electric do not currently have any contracts that are required to be marked
      to
      market. UNS Gas does have a natural gas supply and management agreement under
      which it purchases substantially all of its gas requirements at market prices
      from BP Energy Company (BP). However, the contract terms allow UNS Gas to lock
      in fixed prices on a portion of its gas purchases by entering into fixed price
      forward contracts with BP at various times during the year. This enables UNS
      Gas
      to provide more stable prices to its customers. These purchases are made up
      to
      three years in advance with the goal of locking in fixed prices on at least
      45%
      and not more than 80% of the expected monthly gas consumption prior to entering
      into the month. These forward contracts, as well as the main gas supply
      contract, meet the definition of normal purchases and therefore are not required
      to be marked to market.





MEG,
      a wholly-owned
      subsidiary of Millennium, enters into swap agreements, options and forward
      contracts relating to Emission Allowances. MEG marks its trading contracts
      to
      market by recording unrealized gains and losses and adjusting the related assets
      and liabilities on a monthly basis to reflect the market prices at the end
      of
      the month. In accordance with UniSource Energy’s intention to cease making
      capital contributions to Millennium, Millennium has significantly reduced the
      holdings and activity of MEG. MEG’s activities consist of managing a small
      number of remaining positions, including a hedge, which are expected to close
      by
      early 2008.





The
      market prices
      used to determine fair values for TEP and MEG’s derivative instruments at March
      31, 2006, are estimated based on various factors including broker quotes,
      exchange prices, over the counter prices and time value. For TEP’s forward power
      contracts, a 10% decrease in market prices would result in a decrease in
      unrealized losses of $1 million, while a 10% increase in market prices would
      result in an increase in unrealized losses of $1 million. For TEP’s forward
      contracts that are accounted for as cash flow hedges, a 10% decrease in market
      prices would result in a $2 million decrease in unrealized losses reported
      in
      Other Comprehensive Income, while a 10% increase in market prices would result
      in a $2 million increase in unrealized losses reported in Other Comprehensive
      Income. For TEP’s gas swap agreements, a 10% decrease in market prices would
      result in a $4 million decrease in unrealized gains reported in Other
      Comprehensive Income, while a 10% increase in market prices
      would result
      in a $4 million increase in unrealized gains reported in Other Comprehensive
      Income. For MEG’s remaining trading contracts, a 10% decrease in market prices
      or a 10% increase in market prices would be less than $0.1 million. The
      unrealized gains and losses are reversed as contracts settle and realized gains
      or losses are recorded.





Because
      of the
      complexity of derivatives, the FASB established a Derivatives Implementation
      Group (DIG). To date, the DIG has issued more than 100 interpretations to
      provide guidance in applying Statement of Financial Accounting Standards No.
      133, *Accounting
      for
      Derivative Instruments and Hedging Activities* (FAS 133).




56




As
      the DIG or the FASB continues to issue interpretations, TEP, UNS Gas and UNS
      Electric may change the conclusions they have reached and, as a result, the
      accounting treatment and financial statement impact could change in the
      future.





See *Market
      Risks -
      Commodity Price Risk* in
      Item
      3.





**UNBILLED
      REVENUE - TEP AND UES**





TEP’s,
      UNS Gas’s
      and UNS Electric’s retail revenues include an estimate of MWhs/therms delivered
      but unbilled at the end of each period. Unbilled revenues are dependent upon
      a
      number of factors that require management’s judgment including estimates of
      retail sales and customer usage patterns. The unbilled revenue is estimated
      by
      comparing the estimated MWhs/therms delivered to the MWhs/therms billed to
      TEP,
      UNS Gas and UNS Electric retail customers. The excess of estimated MWhs/therms
      delivered over MWhs/therms billed is then allocated to the retail customer
      classes based on estimated usage by each customer class. TEP, UNS Gas and UNS
      Electric then record revenue for each customer class based on the various bill
      rates for each customer class. Due to the seasonal fluctuations of TEP’s actual
      load, the unbilled revenue amount increases during the spring and summer months
      and decreases during the fall and winter months. The unbilled revenue amount
      for
      UNS Gas sales increases during the fall and winter months and decreases during
      the spring and summer months, whereas, the unbilled revenue amount for UNS
      Electric sales increases during the spring and summer months and decreases
      during the fall and winter months.





**PLANT
      ASSET
      DEPRECIABLE LIVES - TEP AND UES**





We
      calculate
      depreciation expense based on our estimate of the useful lives of our plant
      assets. The estimated useful lives, and resulting depreciation rates used to
      calculate depreciation expense for the transmission and distribution businesses
      of TEP, UNS Gas and UNS Electric have been approved by the ACC in prior rate
      decisions. Depreciation rates for transmission and distribution cannot be
      changed without ACC approval.





The
      estimated
      remaining useful lives of TEP’s generating facilities are based on management’s
      best estimate of the economic life of the units. These estimates are based
      on
      engineering estimates, economic analysis, and statistical analysis of TEP’s past
      experience in maintaining the stations. Our generation assets are currently
      depreciated over periods ranging from 23 to 70 years from the original
      in-service dates.





During
      the second
      quarter of 2005, a study requested by the participants in the San Juan
      Generating Station was completed which indicated San Juan’s economic useful life
      had changed from previous estimates. As a result of the study and other analysis
      performed, TEP lengthened the estimated useful life of San Juan from 40 to
      60
      years beginning April 1, 2005. TEP’s annual depreciation expense related to San
      Juan is expected to decrease by $6 million beginning in 2006.




**DEFERRED
      TAX VALUATION - TEP AND MILLENNIUM**





We
      record deferred
      tax liabilities for amounts that will increase income taxes on future tax
      returns. We record deferred tax assets for amounts that could be used to reduce
      income taxes on future tax returns. We record a valuation allowance, or reserve,
      for the deferred tax asset amount that we may not be able to use on future
      tax
      returns. We estimate the valuation allowance based on our interpretation of
      the
      tax rules, prior tax audits, tax planning strategies, scheduled reversal of
      deferred tax liabilities, and projected future taxable income.





At
      March 31, 2006,
      UniSource Energy had no valuation allowance. At December 31, 2005, UniSource
      Energy had a valuation allowance of $7 million relating to net operating loss
      (NOL) carryforward amounts.





The
      $7 million
      valuation allowance balance at December 31, 2005, relates to losses generated
      by
      the Millennium entities. As a result of the sale of Global Solar the NOL and
      related valuation allowance were removed from
      the UniSource
      Energy consolidated balance sheet. See Note 3 of *Notes
      To
      Condensed Consolidated Financial Statements* .




As
      of March 31,
      2006 and December 31, 2005, UniSource Energy’s deferred income tax assets
      include $6 million and $9 million, respectively, related to unregulated
      investment losses of Millennium. These losses have not been reflected on
      UniSource Energy’s consolidated income tax returns. If UniSource Energy were
      unable to recognize such losses through its consolidated income tax return
      in
      the foreseeable future, UniSource Energy would be required to write off these
      deferred tax assets.




57





**NEWACCOUNTING
      PRONOUNCEMENTS**





The
      FASB recently
      issued the following Statements of Financial Accounting Standards (FAS) and
      FASB
      Staff Positions (FSP):





· FAS
      155, Accounting for Certain Hybrid Financial Instruments, issued February
      2006, permits fair value remeasurement for
      any hybrid financial instrument that contains an embedded derivative that
      had previously been bifurcated pursuant to Statement 133 and eliminates a
      restriction in Statement 140 on the passive derivative instruments that a
      qualifying special-purpose entity may hold.  FAS 155 is
      effective for all financial instruments acquired or issued or subject to
      remeasurement in fiscal year that begin after September 15, 2006.  We
      are evaluating the impact of FAS 155 on our financial statements.




· FSP
      FASB Technical Bulletin 85-4-1, *Accounting
      for
      Life Settlement Contracts by Third-Party Investors,* issued March 2006,
      allows an investor to account for its investment in a life settlement contract
      using either the investment method or the fair value method in periods
      subsequent to the initial recognition of the investment.  Investments
      accounted for under the investment method are initially recorded at transaction
      price (the amount the investor pays to the insured party) plus any initial
      direct external costs.  Subsequent costs to keep the policy in force are
      capitalized to the carrying amount. When the insured dies, the investor
      recognizes, in the income statement, the difference between the carrying amount
      of the investment in the life settlement contract and the life insurance
      proceeds of the underlying life insurance policy. Investments accounted for
      under the fair value method are initially recorded at transaction price and
      are
      subsequently remeasured to fair value each reporting period with changes in
      fair
      value recognized in earnings in the period of the change.  FSP FASB
      Technical Bulletin 85-4-1 is effective fiscal years beginning after June 15,
      2006.  We are evaluating the impact of FSP FASB Technical Bulletin 85-4-1
      on our financial statements.





**SAFEHARBOR
      FOR FORWARD-LOOKING
      STATEMENTS**





This
      Quarterly
      Report on Form 10-Q contains forward-looking statements as defined by the
      Private Securities Litigation Reform Act of 1995. UniSource Energy and TEP
      are
      including the following cautionary statements to make applicable and take
      advantage of the safe harbor provisions of the Private Securities Litigation
      Reform Act of 1995 for any forward-looking statements made by or for UniSource
      Energy or TEP in this Quarterly Report on Form 10-Q. Forward-looking statements
      include statements concerning plans, objectives, goals, strategies, future
      events or performance and underlying assumptions and other statements that
      are
      not statements of historical facts. Forward-looking statements may be identified
      by the use of words such as “anticipates”, “estimates”, “expects”, “intends”,
“plans”, “predicts”, “projects”, and similar expressions. From time to time, we
      may publish or otherwise make available forward-looking statements of this
      nature. All such forward-looking statements, whether written or oral, and
      whether made by or on behalf of UniSource Energy or TEP, are expressly qualified
      by these cautionary statements and any other cautionary statements which may
      accompany the forward-looking statements. In addition, UniSource Energy and
      TEP
      disclaim any obligation to update any forward-looking statements to reflect
      events or circumstances after the date of this report.





Forward-looking
      statements involve risks and uncertainties, which could cause actual results
      or
      outcomes to differ materially from those expressed in the forward-looking
      statements. We express our expectations, beliefs and projections in good faith
      and believe them to have a reasonable basis. However, we make no assurances
      that
      management’s expectations, beliefs or projections will be achieved or
      accomplished. We have identified the following important factors that could
      cause actual results to differ materially from those discussed in our
      forward-looking statements. These may be in addition to other factors and
      matters discussed in other parts of this report:




1.
            Supply
                  and
                  demand conditions in wholesale energy markets, including volatility
                  in
                  market prices and illiquidity in markets, which are affected by
                  a variety
                  of factors. These factors include the availability of generating
                  capacity
                  in the western U.S., including hydroelectric resources, weather,
                  natural
                  gas prices, the extent of utility restructuring in various states,
                  transmission constraints, environmental regulations and cost of
                  compliance, FERC regulation of wholesale energy markets, and economic
                  conditions in the western
                  U.S.




2.
            Effects
                of
                competition in retail and wholesale energy
                markets.





3.
            Changes
                in
                economic conditions, demographic patterns and weather conditions
                in our
                retail service areas.




58




4.
            Effects
                of
                restructuring initiatives in the electric industry and other
                energy-related industries.





5.
            The
                creditworthiness of the entities with which we transact business
                or have
                transacted business.





6.
            Changes
                affecting our cost of providing electric and gas service including
                changes
                in fuel costs, generating unit operating performance, scheduled and
                unscheduled plant outages, interest rates, tax laws, environmental
                laws,
                and the general rate of inflation.





7.
            Changes
                in
                governmental policies and regulatory actions with respect to financing
                and
                rate structures.





8.
            Changes
                affecting the cost of competing energy alternatives, including changes
                in
                available generating technologies and changes in the cost of natural
                gas.





9.
            Changes
                in
                accounting principles or the application of such principles to our
                businesses.





10.
            Changes
                in
                the depreciable lives of our assets.





11.
            Unanticipated
                changes in funding requirements, future liabilities and recorded
                expense
                relating to employee benefit plans due to changes in market values
                of
                retirement plan assets and health care costs, changes in accounting
                requirements of the FASB and new
                legislation.





12.
            The
                outcome
                of any ongoing or future
                litigation.





13.
            Ability
                to
                obtain financing through debt and/or equity issuance, which can be
                affected by various factors, including interest rate fluctuations
                and
                capital market conditions.




**ITEM3.
      - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK**





**MARKET
      RISKS**





The
      information
      contained in this Item updates, and should be read in conjunction with,
      information included in Part II, Item 7A in UniSource Energy and TEP’s Annual
      Report on Form 10-K for the year ended December 31, 2005, in addition to the
      interim condensed consolidated financial statements and accompanying notes
      presented in Items 1 and 2 of this Form 10-Q.





We
      are exposed to
      various forms of market risk. Changes in interest rates, returns on marketable
      securities, and changes in commodity prices may affect our future financial
      results. The market risks resulting from changes in interest rates and returns
      on marketable securities have not changed materially from the market risks
      reported in the 2005 Annual Report on Form 10-K.  For
      additional
      information concerning risk factors, including market risks, see *Safe
      Harbor for
      Forward-Looking Statements* ,
      above.





**Risk
      Management Committee**





We
      have a Risk
      Management Committee responsible for the oversight of commodity price risk
      and
      credit risk related to the wholesale energy marketing activities of TEP, the
      emissions and trading activities of MEG, and the fuel and power procurement
      activities at TEP and UES. Our Risk Management Committee, which meets on a
      quarterly basis and as needed, consists of officers from the finance,
      accounting, legal, wholesale marketing, transmission and distribution
      operations, and the generation operations departments of UniSource Energy.
      To limit
      TEP’s, UES’ and MEG’s exposure to commodity price risk, the Risk Management
      Committee sets trading and hedging policies and limits, which are reviewed
      frequently to respond to constantly changing market conditions. To limit TEP’s,
      UES’ and MEG’s exposure to credit risk, the Risk Management Committee reviews
      counterparty credit exposure, as well as credit policies and
      limits.





**Commodity
      Price Risk**





We
      are exposed to
      commodity price risk primarily relating to changes in the market price of
      electricity, natural gas, coal and emission allowances.




59




**TEP**





Purchases
      and
      Sales of Energy





To
      manage its
      exposure to energy price risk, TEP enters into forward contracts to buy or
      sell
      energy at a specified price and future delivery period. Generally, TEP commits
      to future sales based on expected excess generating capability, forward prices
      and generation costs, using a diversified market approach to provide a balance
      between long-term, mid-term and spot energy sales. TEP generally enters into
      forward purchases during its summer peaking period to ensure it can meet its
      load and reserve requirements and account for other contracts and resource
      contingencies. TEP also enters into limited forward purchases and sales to
      optimize its resource portfolio and take advantage of locational differences
      in
      price. These positions are managed on both a volumetric and dollar basis and
      are
      closely monitored using risk management policies and procedures overseen by
      the
      Risk Management Committee. For example, the risk management policies provide
      that TEP should not take a short position in the third quarter and must have
      owned generation backing up all forward sales positions at the time the sale
      is
      made. TEP’s risk management policies also restrict entering into forward
      positions with maturities extending beyond the end of the next calendar year
      except for approved hedging purposes.





The
      majority of
      TEP’s forward contracts are considered to be “normal purchases and sales” of
      electric energy and are not considered to be derivatives under FAS 133. TEP
      records revenues on its “normal sales” and expenses on its “normal purchases” in
      the period in which the energy is delivered. From time to time, however, TEP
      enters into forward contracts that meet the definition of a derivative under
      FAS
      133. When TEP has derivative forward contracts, it marks them to market using
      actively quoted prices obtained from brokers for power traded over-the-counter
      at Palo Verde and at other southwestern U.S. trading hubs. TEP believes that
      these broker quotations used to calculate the mark-to-market values represent
      accurate measures of the fair values of TEP’s positions, because of the
      short-term nature of TEP’s positions, as limited by risk management policies,
      and the liquidity in the short-term market.





To
      adjust the value
      of its derivative forward contracts to fair value in Other Comprehensive Income
      and on its income statement, TEP recorded net unrealized losses of $5 million
      in
      Other Comprehensive Income for the three months ended March 31, 2006, and gains
      of $6 million in Other Comprehensive Income for the same period in 2005. TEP
      also recorded net unrealized gains of $1 million in Wholesale Sales for the
      first three months of 2006, and zero net unrealized gains or losses in Wholesale
      Sales for the same period in 2005.





TEP
      uses
      sensitivity analysis to measure the impact of an unfavorable change in market
      prices on the fair value of its derivative forward contracts. As of March 31,
      2006, for TEP’s forward power contracts (a majority of which are sales
      contracts), a 10% decrease in market prices would result in a decrease in
      unrealized losses of $1 million, while a 10% increase in market prices would
      result in an increase in unrealized losses of $1 million. For TEP’s forward
      contracts that are accounted for as cash flow hedges (a majority of which are
      sales contracts), a 10% decrease in market prices would result in a $2 million
      decrease in unrealized losses reported in Other Comprehensive Income, while
      a
      10% increase in market prices would result in a $2 million increase in
      unrealized losses reported in Other Comprehensive Income. The unrealized gains
      and losses are reversed as contracts settle and realized gains or losses are
      recorded.




Natural
      Gas





TEP
      is also subject
      to commodity price risk from changes in the price of natural gas. In addition
      to
      energy from its coal-fired facilities, TEP typically uses purchased power,
      supplemented by generation from its gas-fired units, to meet the summer peak
      demands of its retail customers and to meet local reliability needs. Some of
      these purchased power contracts are price indexed to natural gas prices.
      Short-term and spot power purchase prices are also closely correlated to natural
      gas prices. Due to its increasing seasonal gas and purchased power usage, TEP
      hedges a portion of its total natural gas exposure from plant fuel, gas-indexed
      purchase power and spot market purchases with fixed price contracts for a
      maximum of three years. TEP purchases its remaining gas fuel needs and purchased
      power in the spot and short-term markets.





In
      the first quarter of 2006, the average market price of natural gas was $7.14
      per
      MMBtu, or 29% higher than the same period in 2005. The table below summarizes
      TEP’s gas generation output and purchased power for the first quarters of 2006
      and 2005.




60




**Three
                Months Ended March 31,**
            
            **2006**
            
            **2005**
            
            **2006**
            
            **2005**-MWh-
            
            %
                of Total
                ResourcesGas-Fired
                Generation
            
            
            35,000
            
            
            56,000
            
            
            1
            %
            
            2
            %Purchased
                Power
            
            
            310,000
            
            
            265,000
            
            
            10
            %
            
            10
            %





As
      of March 31, 2006, for TEP’s gas swap agreements, a 10% decrease in market
      prices would result in a $4 million decrease in unrealized gains reported in
      Other Comprehensive Income, while a 10% increase in market prices would result
      in a $4 million increase in unrealized gains reported in Other Comprehensive
      Income.





Coal





TEP
      is subject to
      commodity price risk from changes in the price of coal used to fuel its
      coal-fired generating plants. The commodity price risk from changes in the
      price
      of coal have not changed materially from the commodity price risks reported
      in
      the 2005 Annual Report on Form 10-K.





**UES**





UES
      is also subject
      to commodity price risk, primarily from the changes in the price of natural
      gas
      purchased for its UNS Gas customers. This risk is mitigated through the PGA
      mechanism which provides an adjustment to UNS Gas’ retail rates to recover the
      actual costs of gas and transportation. UNS Gas further reduces this risk by
      purchasing forward fixed price contracts for a portion of its projected gas
      needs under its Price Stabilization Plan. UNS Gas purchases at least 45% of
      its
      estimated gas needs in this manner.





UNS
      Electric is not
      exposed to commodity price risk for its purchase of electricity as it has a
      fixed price full-requirements supply agreement with PWCC through May
      2008.





**MEG**





MEG
      trades
      emissions allowances and related instruments; however, MEG’s current activities
      consist of managing a small number of remaining positions, including a hedge,
      which are expected to close by early 2008. We manage the market risk of this
      line of business by setting notional limits by product, as well as limits to
      the
      potential change in fair market value under a 33% change in price or volatility.
      We closely monitor MEG’s trading activities, which include swap agreements,
      options and forward contracts, using risk management policies and procedures
      overseen by the Risk Management Committee.





MEG
      marks its
      trading positions to market on a daily basis using actively quoted prices
      obtained from brokers and options pricing models for positions that extend
      through 2007. As of March 31, 2006 and December 31, 2005, the fair value of
      MEG’s trading assets combined with Emissions Allowances it holds in escrow was
      $15 million and $38 million, respectively. The fair value of MEG’s trading
      liabilities was $5 million at March 31, 2006 and $24 million at December 31,
      2005. For the first quarter of 2006, MEG reflected a $3 million unrealized
      loss
      and an $3 million realized gain on its income statement, compared with an
      unrealized loss of $2 million and a realized gain of $2 million in the first
      quarter of 2005. For MEG’s remaining trading contracts at March 31, 2006, a 10%
      decrease in market prices or a 10% increase in market prices would be
      immaterial.





Unrealized
                Gain (Loss) of MEG’s Trading Activities-
                Millions of
                Dollars -Source
                of
                Fair Value At March 31, 2006
            
            
            Maturity
                0 - 6 months
            
            
            Maturity
                6 - 12 months
            
            
            Maturity
                over 1 yr.
            
            
            Total
                Unrealized Gain (Loss)Prices
                actively quoted
            
            $
            1
            
            $
            1
            
            $
            1
            
            $
            3Prices
                based on models and other valuation methods
            
            
            -
            
            
            -
            
            
            6
            
            
            6Total
            
            $
            1
            
            $
            1
            
            $
            7
            
            $
            9




**Credit
      Risk**




UniSource
      Energy is
      exposed to credit risk in its energy-related marketing and trading activities
      related to potential nonperformance by counterparties. We manage the risk of
      counterparty default by performing financial credit reviews, setting limits,
      monitoring exposures, requiring collateral when needed, and using a standard
      agreement which allows for the netting of current period exposures to and from
      a
      single counterparty.




61





We
      calculate
      counterparty credit exposure by adding any outstanding receivable (net of
      amounts payable if a netting agreement exists) to the mark-to-market value
      of
      any forward contracts. As of March 31, 2006, TEP’s total credit exposure related
      to its wholesale marketing and gas hedging activities was approximately $22
      million. Less than $1 million of TEP’s exposure is to non-investment grade
      companies. TEP had four counterparties with exposures of greater than 10% of
      its
      total credit exposure, totaling approximately $19 million. MEG’s total credit
      exposure related to its trading activities was $9 million and was concentrated
      primarily with one counterparty. MEG has no credit exposure to non-investment
      grade counterparties.





UNS
      Gas is subject
      to credit risk from non-performance by its supply counterparty, BP Energy (BP),
      to the extent that this contract has a mark-to-market value in favor of UNS
      Gas.
      As of March 31, 2006, UNS Gas has purchased under fixed price contracts
      approximately 37% of its expected consumption for the 2006/2007 winter season.
      At March 31, 2006, the supply contract with BP was in a favorable mark-to-market
      position for UNS Gas. When netted against amounts owed to BP, this credit
      exposure was less than $1 million.




**ITEM4.
      - CONTROLS AND PROCEDURES**








UniSource
      Energy
      and TEP’s Chief Executive Officer and Chief Financial Officer supervised and
      participated in UniSource Energy and TEP’s evaluation of their disclosure
      controls and procedures as such term is defined under Rule 13a - 15(e) or Rule
      15d - 15(e) under the Securities Exchange Act of 1934, as amended (the Exchange
      Act), as of March 31, 2006. Disclosure controls and procedures are controls
      and
      procedures designed to ensure that information required to be disclosed in
      UniSource Energy and TEP’s periodic reports filed or submitted under the
      Exchange Act, is recorded, processed, summarized and reported within the time
      periods specified in the Securities and Exchange Commission’s rules and forms.
      These disclosure controls and procedures can only provide reasonable, not
      absolute, assurance that the above objectives have been met. Based upon the
      evaluation performed, UniSource Energy and TEP’s Chief Executive Officer and
      Chief Financial Officer concluded that UniSource Energy and TEP’s disclosure
      controls and procedures are effective.





While
      UniSource
      Energy and TEP continually strive to improve their disclosure controls and
      procedures to enhance the quality of their financial reporting, there has been
      no change in UniSource Energy or TEP’s internal control over financial reporting
      during the first quarter of 2006, that has materially affected, or is reasonably
      likely to materially affect, UniSource Energy or TEP’s internal control over
      financial reporting.





UniSource
      Energy’s
      Management’s Report on Internal Control Over Financial Reporting Under 404 of
      Sarbanes-Oxley appears as the first report under Item 8 in UniSource Energy’s
      and TEP’s 2005 Annual Report on Form 10-K and the Report of Independent
      Registered Public Accounting Firm appears as the second report under Item
      8.




**PARTII
      - OTHER INFORMATION**





**ITEM1.
      - LEGAL PROCEEDINGS**





We
      discuss other
      legal proceedings in *Note
      6
      of*  *Notes
      to
      Consolidated Financial Statements, Commitments and
      Contingencies.*





**Cross-Complaints
      in Wholesale Electricity Antitrust Cases I and II**




In
      late 2000,
      various California municipalities and citizens filed suits against Duke Energy
      Trading and Marketing, L.L.C., Reliant Energy Services, Inc. and other large
      suppliers of wholesale electricity alleging that Duke, Reliant, and the other
      large suppliers violated antitrust laws by colluding to effect the price of
      electricity in the California wholesale electricity market.  These actions
      were subsequently consolidated in San Diego Superior Court in March 2002 as
      Wholesale Electricity Antitrust Cases I and II.




Duke
      and Reliant
      responded by filing cross-complaints against TEP and numerous other wholesale
      electricity market participants in April 2002.  The cross complaints allege
      that cross-defendants sold power in significant amounts at prices the plaintiffs
      allege were excessive, and as participants in power sales, cross-defendants
      are
      also liable for plaintiffs alleged damages.  The entire action was removed
      to the United States




62




District
      Court for
      the Southern District of California in May 2002.  The plaintiffs responded
      to the removal by filing a motion for remand, and in December 2002, the District
      Court remanded the case back to state court.




Duke
      and Reliant
      appealed the District Court’s remand order and requested that the order be
      stayed pending resolution of their appeal.  In December 2004, the Ninth
      Circuit affirmed the District Court’s order and the case was remanded to the
      state court. Once there, the defendants filed a joint motion to dismiss to
      the
      master complaint and TEP and other cross-defendants filed a joint motion to
      dismiss to the cross-complaints.





On
      October 3, 2005, the state court sustained defendants’ joint motion to dismiss
      and dismissed the master complaint without leave to amend. Before a hearing
      was
      held on the cross-defendants’ motion to dismiss, Duke and Reliant entered into
      stipulations for dismissal of their cross-complaints with TEP and the other
      cross-defendants. The stipulations provided that orders of dismissal would
      be
      entered upon final approval of Duke and Reliant’s pending settlement with the
      plaintiffs. On March 14, 2006, the state court granted final approval of the
      Duke settlement. Accordingly, TEP has been dismissed, from the Duke antitrust
      proceeding, subject to any appeals. Final approval of the Reliant settlement
      is
      still pending.




**City
      of
      Tacoma**




In
      June 2004, the
      City of Tacoma, Washington filed a lawsuit (City of Tacoma v. American Electric
      Power Services Corporation, et al. (U.S. District Ct.  W. D. Wash.))
      against TEP and various other electricity generators and marketers alleging
      that
      the defendants violated antitrust laws by colluding to affect the price of
      electricity in the Pacific Northwest from May 2000 through 2001.  These
      claims are similar to those alleged in the antitrust cases against TEP and
      other
      wholesale electricity market participants described above in Cross-Complaints
      in
      Wholesale Electricity Antitrust Cases I and II.  In September 2004, the
      case was transferred to the United States District Court for the Southern
      District of California.  TEP along with other defendants filed a joint
      motion to dismiss and the motion was granted on February 11, 2005. The City
      of
      Tacoma appealed the dismissal to the Ninth Circuit and the appeal is now
      pending.




TEP
      believes these
      claims are without merit and intends to vigorously contest them.





**ITEM1A.
      - RISK FACTORS**





The
      business and
      financial results of UniSource Energy and TEP are subject to numerous risks
      and
      uncertainties. The risks and uncertainties have not changed materially from
      those reported in the 2005 Annual Report on Form 10-K.




**ITEM5.
      - OTHER INFORMATION**





**NON-GAAP
      MEASURES**





**Adjusted
      EBITDA**





Adjusted
      EBITDA
      represents EBITDA excluding the cumulative effect of accounting change which
      is
      a non-cash item. EBITDA is earnings before interest, taxes, depreciation and
      amortization. Adjusted EBITDA is presented here as a measure of liquidity
      because it can be used as an indication of a company’s ability to incur and
      service debt and is commonly used as an analytical indicator in our industry.
      Adjusted EBITDA measures presented may not be comparable to similarly titled
      measures used by other companies. Adjusted EBITDA is not a measurement presented
      in accordance with United States generally accepted accounting principles
      (GAAP), and we do not intend Adjusted EBITDA to represent cash flows from
      operations as defined by GAAP. Adjusted EBITDA should not be considered to
      be an
      alternative to cash flows from operations or any other items calculated in
      accordance with GAAP or an indicator of our operating performance.





UniSource
      Energy
      and TEP view Adjusted EBITDA, a non-GAAP financial measure, as a liquidity
      measure. The most directly comparable GAAP measure to Adjusted EBITDA is Net
      Cash Flows from Operating Activities.





63





**Adjusted
      EBITDA and Net Cash Flows from Operating Activities**





**Three
                Months Ended March 31,****UniSource
                Energy**
            
            **2006**
            
            **2005**-
                Millions of
                Dollars -Adjusted EBITDA
            
            $
            116
            
            $
            82Net
                Cash Flows from Operating Activities
            
            $
            52
            
            $
            40








**Three
                Months Ended March 31,****TEP**
            
            **2006**
            
            **2005**-
                Millions of
                Dollars -Adjusted EBITDA
            
            $
            100
            
            $
            71Net
                Cash Flows from Operating Activities
            
            $
            43
            
            $
            37






**Reconciliation
      of Adjusted EBITDA to Cash Flows from Operations**




**Three
                Months EndedMarch 31,****UniSource
                Energy**
            
            **2006**
            
            **2005**-
                Millions of
                Dollars -**Adjusted
                EBITDA****(1)******
            
            $
            116
            
            $
            82Amounts
                from
                the Income Statements:Less: Income Taxes
            
            
            14
            
            
            (1
            )Less: Total Interest Expense
            
            
            37
            
            
            40Changes
                in
                Assets and Liabilities and Other Non-Cash Items
            
            
            (13
            )
            
            (3
            )**Net
                Cash Flows from Operating Activities**
            
            **$**
            **52**
            
            **$**
            **40**





**Three
                Months EndedMarch 31,****TEP**
            
            **2006**
            
            **2005**-
                Millions of
                Dollars -**Adjusted
                EBITDA****(1)******
            
            $
            100
            
            $
            71Amounts
                from
                the Income Statements:Less:
                Income Taxes
            
            
            12
            
            
            (2
            )Less:
                Total Interest Expense
            
            
            31
            
            
            37Changes
                in
                Assets and Liabilities and Other Non-Cash Items
            
            
            (14
            )
            
            1**Net
                Cash Flows from Operating Activities**
            
            **$**
            **43**
            
            **$**
            **37**





**(1)** **Adjusted
      EBITDA was calculated as follows:**




**Three
                  Months EndedMarch 31,****UniSource
                  Energy**
              
              
              **2006**
              
              
              **2005**-
                  Millions of
                  Dollars -**Net
                  Income**
              
              $
              17
              
              $
              (4
              )Amounts
                  from
                  the Income Statements:Less:
                  Discontinued Operations - Net of Tax
              
              
              (3
              )
              
              (1
              )Plus:Income
                  Taxes
              
              
              14
              
              
              (1
              )Total
                  Interest Expense
              
              
              37
              
              
              40Depreciation
                  and Amortization
              
              
              31
              
              
              35Amortization
                  of Transition Recovery Asset
              
              
              12
              
              
              9Depreciation
                  included in Fuel and Other O&M Expense
                  (see
                  Note 13 of Notes to Consolidated Financial
                  Statements)
              
              
              2
              
              
              2**Adjusted
                  EBITDA**
              
              **$**
              **116**
              
              **$**
              **82**
  64




**Three
                  Months EndedMarch 31,****TEP**
              
              **2006**
              
              **2005**-
                  Millions of
                  Dollars -**Net
                  Income**
              
              $
              17
              
              $
              (5
              )Amounts
                  from
                  the Income Statements:Plus:
                  Income
                  Taxes
              
              
              12
              
              
              (2
              )Total
                  Interest Expense
              
              
              31
              
              
              37Depreciation
                  and Amortization
              
              
              26
              
              
              30Amortization
                  of Transition Recovery Asset
              
              
              12
              
              
              9Depreciation
                  included in Fuel and Other O&M Expense
                  (see
                  Note 13 of Notes to Consolidated Financial
                  Statements)
              
              
              2
              
              
              2**Adjusted
                  EBITDA**
              
              **$**
              **100**
              
              **$**
              **71**
  **Net
        Debt
        and Total Debt and Capital Lease Obligations -
        TEP**





Net
      Debt represents
      the current and non-current portions of TEP’s long-term debt and capital lease
      obligations less investment in lease debt. We have subtracted investment in
      lease debt because it represents TEP’s ownership of the debt component of its
      own capital lease obligations. Net Debt measures presented may not be comparable
      to similarly titled measures used by other companies. Net Debt is not a
      measurement presented in accordance with GAAP and we do not intend Net Debt
      to
      represent debt as defined by GAAP. You should not consider Net Debt to be an
      alternative to debt or any other items calculated in accordance with
      GAAP.





**As
                ofMarch 31, 2006**
            
            **As
                of
                December 31, 2005**-
                Millions of
                Dollars -Net
                Debt
            
            $
            1,345
            
            $
            1,379Total
                Debt
                and Capital Lease Obligations
            
            $
            1,491
            
            $
            1,535





**Reconciliation
      of Total Debt and Capital Lease Obligations to Net Debt**





**As
                of**
              **March
                31, 2006**
            
            **As
                of
                December 31, 2005**-
                Millions of
                Dollars -Long-Term
                Debt
            
            $
            821
            
            $
            821Current
                Portion - Long-Term Debt
            
            
            -
            
            
            -**Total Debt**
            
            
            821
            
            
            821Capital
                Lease
                Obligations
            
            
            615
            
            
            665Current
                Portion - Capital Lease Obligations
            
            
            55
            
            
            49**Total Debt and Capital Lease Obligations**
            
            
            1,491
            
            
            1,535Investment
                in
                Lease Debt
            
            
            (146
            )
            
            (156
            )**Net Debt**
            
            $
            1,345
            
            $
            1,379




65




**Ratioof
      Earnings to Fixed
      Charges**





The
      following table
      reflects the ratio of earnings to fixed charges for UniSource Energy and
      TEP:




**3
                Months Ended**
            **12
                Months Ended****March
                31, 2006**
            **March
                31, 2006**UniSource
                Energy
            1.86
            1.79TEP
            1.87
            1.89




**SECReports
      Available on UniSource Energy’s
      Website**





UniSource
      Energy
      and TEP make available their annual reports on Form 10-K, quarterly reports
      on
      Form


10-Q,
      current
      reports on Form 8-K, and all amendments to those reports as soon as reasonably
      practicable after they electronically file them with, or furnish them to, the
      SEC. These reports are available free of charge through UniSource
      Energy’s
      website address: http://www.uns.com .
      A link from
      UniSource Energy’s website to these SEC reports is accessible as follows: At the
      UniSource Energy main page, select Investor Relations from the menu shown at
      the
      top of the page; next select SEC filings from the menu shown on the Investor
      Relations page.





*Information
      contained at UniSource Energy’s website is not part of any report filed with the
      SEC by UniSource Energy or TEP.*





The
      SEC also
      maintains an Internet site that contains reports, proxy and information
      statements, and other information regarding issuers that file electronically
      with the SEC. The SEC website address is http://www.sec.gov .
      Interested
      parties may also read and copy any materials UniSource Energy or TEP file with the
      SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC
      20549. Information on the operation
      of the
      Public Reference Room is available by calling the SEC at
      1-800-SEC-0030.




**ITEM6.
      - EXHIBITS**





See
      Exhibit
      Index.





66




**SIGNATURES**




Pursuant
      to the
      requirements of the Securities Exchange Act of 1934, each registrant has duly
      caused this report to be signed on its behalf by the undersigned thereunto
      duly
      authorized. The signature for each undersigned company shall be deemed to relate
      only to matters having reference to such company or its
      subsidiaries.




UNISOURCE
                  ENERGY CORPORATION(Registrant)Date:
                  May 5, 2006
              
              /s/Kevin
                  P.
                  LarsonKevin
                  P.
                  LarsonSenior
                  Vice
                  President and PrincipalFinancial
                  Officer


TUCSON
                    ELECTRIC POWER COMPANY(Registrant)Date:
                    May 5,
                    2006
                
                /s/Kevin
                    P.
                    LarsonKevin
                    P.
                    LarsonSenior
                    Vice
                    President and PrincipalFinancial
                    Officer
  67
  **EXHIBITINDEX**




12(a)
            --
            Computation
                of Ratio of Earnings to Fixed Charges -
                UniSource Energy.





12(b)
            --
            Computation
                of Ratio of Earnings to Fixed Charges - TEP.





15
            --
            Letter
                regarding unaudited interim financial
                information.





31(a)
            --
            Certification
                Pursuant to Section 302 of the
                Sarbanes-Oxley Act - UniSource Energy, by James S. Pignatelli.





31(b)
            --
            Certification
                Pursuant to Section 302 of the
                Sarbanes-Oxley Act - UniSource Energy, by Kevin P. Larson.





31(c)
            --
            Certification
                Pursuant to Section 302 of the
                Sarbanes-Oxley Act - TEP, by James S. Pignatelli.





31(d)
            --
            Certification
                Pursuant to Section 302 of the
                Sarbanes-Oxley Act - TEP, by Kevin P.
                Larson.





*32
            --
            Statements
                of Corporate Officers (pursuant to Section 906
                of the Sarbanes-Oxley Act of 2002).





*Pursuant
      to Item
      601(b)(32)(ii) of Regulation S-K, this certificate is not being filed for
      purposes of Section 18 of the
      Securities
      Exchange Act of 1934.




68