Table of
Contents







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, 2008
 
 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
      Employer
                Identification
      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,
a non-accelerated filer, or a smaller reporting company.  See
definition of “accelerated filer,” “large accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.  (Check
one):
  UniSource
      Energy Corporation
                Large
      Accelerated Filer
                X
                Accelerated
      Filer
                
                Non-accelerated
      filer
 Smaller
      Reporting Company
 
 Tucson
      Electric Power Company
                Large
      Accelerated Filer
                
                Accelerated
      Filer
                
                Non-accelerated
      filer
                X
 Smaller
      Reporting Company
 Indicate by check
mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act).
  UniSource
      Energy Corporation
                Yes
                
                No  X
 Tucson
      Electric Power Company
              Yes
              
              No  X
 
 At
May 7, 2008, 34,422,139 shares of UniSource Energy Corporation Common Stock, no
par value (the only class of Common Stock), were outstanding.
 
 At
May 7, 2008, 32,139,434 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
  Tableof Contents
 
 
 Definitions
              iv-- PART I --Reports of Independent Registered Public Accounting
      Firm
              1Item 1. – Financial Statements
              3UniSource Energy
    CorporationComparative Condensed Consolidated
      Statements of Income
              3Comparative Condensed Consolidated
      Statements of Cash Flows
              4Comparative Condensed Consolidated Balance
      Sheets
              5Condensed Consolidated Statement of Changes
      in Stockholders’ Equity and Comprehensive
      IncomeTucson Electric Power
CompanyComparative Condensed Consolidated
      Statements of Income
              8Comparative Condensed Consolidated
      Statements of Cash Flows
              9Comparative Condensed Consolidated Balance
      Sheets
              10Condensed Consolidated Statement of Changes
      in Stockholder’s Equity and Comprehensive
      IncomeNotes to Condensed Consolidated Financial
      Statements
              13Note 1.   Nature of Operations and Basis of
      Accounting Presentation
              13Note 2.   Regulatory
    Matters
              13Note 3.   Debt and Credit
      Facilities
              18Note 4.   Business
    Segments
              19Note 5.   Accounting for Derivative
      Instruments and Trading Activities
              20Note 6.   Income and Other
      Taxes
              23Note 7.   Commitments and
      Contingencies
              24Note 8.   Employee Benefits
      Plans
              26Note 9.   Share-Based Compensation
      Plans
              27Note 10. UniSource Energy Earnings Per Share
      (EPS)
              29Note 11. Discontinued Operations – Sale of Global
      Solar
              32Note 12. New Accounting Pronouncements
              33Note 13. Supplemental Cash Flow
      Information
              34Note 14. Review by Independent Registered Public
      Accounting Firm
              35Item 2. – Management’s Discussion and Analysis of Financial
      Condition and Results of Operations
              36UniSource Energy Consolidated
              36Overview of Consolidated
    Business
              36Outlook and Strategies
              36Results of Operations
              37Contribution by Business
      Segment
              38Liquidity and Capital
    Resources
              38Tucson Electric Power Company
              41Results of Operations
              41Factors Affecting Results of
      Operations
              44Liquidity and Capital Resources
              48UNS Gas
              51Results of Operations
              51Factors Affecting Results of
      Operations
              52Liquidity and Capital
    Resources
              53UNS Electric
              54Results of Operations
              54Factors Affecting Results of
      Operations
              54Liquidity and Capital
    Resources
              56Other Non-Reportable Business
    Segments
              58Results of Operations
              58Critical Accounting
    Estimates
              58New Accounting Pronouncements
              59Safe Harbor for Forward-Looking
      Statements
              60
  ii
 Table of Contents
  Item 3. – Quantitative and Qualitative Disclosures about
      Market Risk
              60Item 4. – Controls and Procedures
              64PART II – OTHER INFORMATIONItem 1. – Legal Proceedings
              65Item 1A. – Risk Factors
              65Item 2. – Unregistered Sale of Equity Securities and
      Use of Proceeds
              65Item 4. – Submission of Matters to a Vote of Security
      Holders
              65Item 5. – Other Information
              66Non-GAAP Measures
              66Ratio of Earnings to Fixed
    Charges
              68Item 6. Exhibits
              68Signatures
              69Exhibit Index
              70
  iii
 Table of Contents
  DEFINITIONS
 
 The abbreviations
and acronyms used in the 2008 first quarter report on Form 10-Q are defined
below:
 
 ACC
                Arizona
      Corporation Commission.AECC
                Arizonans for
      Electric Choice and Competition.AMT
                Alternative
      Minimum Tax.APS
                Arizona
      Public Service.BMGS
                Black
      Mountain Generating Station under development by UED.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.Common
      Stock
                UniSource
      Energy’s common stock, without par value.Company or
      UniSource Energy
                UniSource
      Energy Corporation.Cooling
      Degree Days
                An index used
      to measure the impact of weather on energy usage calculated by subtracting
      75 from the average of the high and daily low
  temperatures.DSM
                Demand side
      management.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.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.Fixed
      CTC
                Competition
      Transition Charge of approximately $0.009 per kWh that is included in
      TEP’s retail rate for the purpose of recovering TEP’s $450 million TRA by
      December 31, 2008.Four
      Corners
                Four Corners
      Generating Station.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.ICRA
                Implementation
      Cost Regulatory Asset.IDBs
                Industrial
      Development Revenue Bonds.IRS
                Internal
      Revenue Service.kWh
                Kilowatt-hour(s).LIBOR
                London
      Interbank Offered Rate.Luna
                Luna Energy
      Facility.Mark-to-Market
      Adjustments
                Forward
      energy sales and purchase contracts that are considered to be derivatives
      are adjusted monthly by recording unrealized gains and losses to reflect
      the market prices at the end of each month.Millennium
                Millennium
      Energy Holdings, Inc., a wholly-owned subsidiary of UniSource
      Energy.MMBtu
                Million
      British Thermal Units.MW
                Megawatt(s).MWh
                Megawatt-hour(s).Navajo
                Navajo
      Generating Station.PGA
                Purchased Gas
      Adjuster, a retail rate mechanism designed to recover the cost of gas
      purchased for retail gas customers.Pima
      Authority
                The
      Industrial Development Authority of the County of Pima.PPFAC
                Purchased
      Power and Fuel Adjustment Clause.
  iv
 Table of Contents
  PWMT
                Pinnacle West
      Marketing and Trading.REST
                Renewable
      Energy Standard and Tariff.RUCO
                Residential
      Utility Consumer Office.Rules
                Retail
      Electric Competition Rules.Salt River
      Project
                A public
      power utility serving more than 900,000 customers in Phoenix,
      Arizona.San
      Juan
                San Juan
      Generating Station.1999
      Settlement Agreement
                TEP’s 1999
      Settlement Agreement approved by the ACC in November 1999 that provided
      for electric retail competition and transition asset
    recovery.SO2
                Sulfur
      dioxide.Springerville
                Springerville
      Generating Station.Springerville
      Coal HandlingFacilities 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 FacilitiesLeases
                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 Leases
                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.Springerville
      Unit 4
                Unit 4 of the
      Springerville Generating Station.SRP
                Salt River
      Project Agricultural Improvement and Power District.Sundt
                H. Wilson
      Sundt Generating Station.Sundt Unit
      4
                Unit 4 of the
      H. Wilson Sundt Generating Station.TCRA
                Termination
      Cost Regulatory Asset.TEP
                Tucson
      Electric Power Company, the principal subsidiary of UniSource
      Energy.TEP Credit
      Agreement
                Amended and
      Restated Credit Agreement between TEP and a syndicate of Banks, dated as
      of August 11, 2006.TEP Letter of
      Credit Facility
                Letter of
      credit facility between TEP and a syndicate of Banks, dated as of April
      30, 2008.TEP Revolving
      Credit Facility
                Revolving
      credit facility under the TEP Credit Agreement.Therm
                A unit of
      heating value equivalent to 100,000 British thermal units
      (Btu).TOU
                Time of
      use.TRA
                Transition
      Recovery Asset, a $450 million regulatory asset established in TEP’s 1999
      Settlement Agreement to be fully recovered by December 31,
      2008.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.UniSource
      Credit Agreement
                Amended and
      Restated Credit Agreement between UniSource Energy and a syndicate of
      banks, dated as of August 11, 2006.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.UNS Gas/UNS
      Electric Revolver
                Revolving
      credit facility under the Amended and Restated Credit Agreement among UNS
      Gas and UNS Electric as borrowers, UES as guarantor, and a syndicate of
      banks, dated as of August 11, 2006.
 v
 Table of Contents
 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, 2008, and
the related condensed consolidated statements of operations for each of the
three-month periods ended March 31, 2008 and 2007, and the condensed
consolidated statement of changes in stockholders' equity and comprehensive
income for the three-month period ended March 31, 2008, and the condensed
consolidated statements of cash flows for the three-month periods ended March
31, 2008 and 2007.  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
(United States), 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, 2007, and the related consolidated statements of income, of cash
flows, of capitalization, and of changes in stockholders' equity and
comprehensive income for the year then ended (not presented herein), and in
our report dated February 26, 2008, we expressed an unqualified opinion on those
consolidated financial statements.  In our opinion, the information
set forth in the accompanying condensed consolidated balance sheet as of
December 31, 2007, 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 1,
2008
  1
 Table of Contents
  Report
of Independent Registered Public Accounting Firm
 
 To
the Board of Directors and Stockholder 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, 2008,
and the related condensed consolidated statements of operation for each of the
three-month periods ended March 31, 2008 and 2007, and the condensed
consolidated statement of changes in stockholder’s equity and comprehensive
income for three-month period ended March 31, 2008, and the condensed
consolidated statements of cash flows for the three-month periods ended March
31, 2008 and 2007.  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
(United States), 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, 2007, and the related consolidated statements of income, of cash
flows, of capitalization, and of changes in stockholder's equity and
comprehensive income for the year then ended (not present herein), and in our
report dated February 26, 2008, we expressed an unqualified opinion on
those consolidated financial statements.  In our opinion, the
information set forth in the accompanying condensed consolidated balance sheet
as of December 31, 2007, 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 1,
2008
  2
 Table of Contents
  PARTI - FINANCIAL INFORMATIONITEM1.  FINANCIAL STATEMENTSUNISOURCEENERGY CORPORATIONCOMPARATIVECONDENSED CONSOLIDATED
      STATEMENTS OF INCOME (LOSS)Three Months
      EndedMarch
      31,2008
                  
                  
                  2007(Unaudited)-Thousands of
      Dollars-(Except Per
      Share Amounts)Operating
      RevenuesElectric
      Retail Sales
                  
                  $
                  197,731
                  
                  
                  $
                  195,750Electric
      Wholesale Sales
                  
                  
                  52,367
                  
                  
                  
                  48,837Gas
      Revenue
                  
                  
                  65,398
                  
                  
                  
                  62,110Other
      Revenues
                  
                  
                  14,638
                  
                  
                  
                  11,144Total
      Operating Revenues
                  
                  
                  330,134
                  
                  
                  
                  317,841Operating
      ExpensesFuel
                  
                  
                  67,950
                  
                  
                  
                  61,080Purchased
      Energy
                  
                  
                  101,873
                  
                  
                  
                  85,807Other
      Operations and Maintenance
                  
                  
                  71,037
                  
                  
                  
                  70,816Depreciation
      and Amortization
                  
                  
                  36,154
                  
                  
                  
                  34,466Amortization
      of Transition Recovery Asset
                  
                  
                  17,250
                  
                  
                  
                  14,986Taxes
      Other Than Income Taxes
                  
                  
                  12,594
                  
                  
                  
                  12,487Total
      Operating Expenses
                  
                  
                  306,858
                  
                  
                  
                  279,642Operating
      Income
                  
                  
                  23,276
                  
                  
                  
                  38,199Other
      Income (Deductions)Interest
      Income
                  
                  
                  3,165
                  
                  
                  
                  4,558Other
      Income
                  
                  
                  3,036
                  
                  
                  
                  1,201Other
      Expense
                  
                  
                  (1,128
                  )
                  
                  
                  (637
                  )Total
      Other Income (Deductions)
                  
                  
                  5,073
                  
                  
                  
                  5,122Interest
      ExpenseLong-Term
      Debt
                  
                  
                  17,245
                  
                  
                  
                  17,989Interest
      on Capital Leases
                  
                  
                  14,336
                  
                  
                  
                  16,152Other
      Interest Expense
                  
                  
                  1,141
                  
                  
                  
                  1,761Interest
      Capitalized
                  
                  
                  (1,548
                  )
                  
                  
                  (1,395
                  )Total
      Interest Expense
                  
                  
                  31,174
                  
                  
                  
                  34,507Income
      (Loss) Before Income Taxes
                  
                  
                  (2,825
                  )
                  
                  
                  8,814Income
      Tax Expense (Benefit)
                  
                  
                  (210
                  )
                  
                  
                  3,871Net
      Income (Loss)
                  
                  $
                  (2,615
                  )
                  
                  $
                  4,943Weighted-average
      Shares of Common Stock Outstanding (000)
                  
                  
                  35,559
                  
                  
                  
                  35,422Basic
      Earnings (Loss) per Share
                  
                  $
                  (0.07
                  )
                  
                  $
                  0.14Diluted
      Earnings (Loss) per Share
                  
                  $
                  (0.07
                  )
                  
                  $
                  0.14Dividends
      Declared per Share
                  
                  $
                  0.240
                  
                  
                  $
                  0.225See Notes to
      Condensed Consolidated Financial Statements.
  3
 Table of Contents
  UNISOURCE
      ENERGY CORPORATIONCOMPARATIVECONDENSED CONSOLIDATED
      STATEMENTS OF CASH FLOWSThree Months
      Ended
                    March
      31,2008
                  
                  
                  2007(Unaudited)-Thousands of
      Dollars-Cash
      Flows from Operating ActivitiesCash
      Receipts from Electric Retail Sales
                  
                  $
                  230,195
                  
                  
                  $
                  228,431Cash
      Receipts from Electric Wholesale Sales
                  
                  
                  78,889
                  
                  
                  
                  95,079Cash
      Receipts from Gas Sales
                  
                  
                  75,021
                  
                  
                  
                  74,131Cash
      Receipts from Operating Springerville Unit 3
                  
                  
                  13,490
                  
                  
                  
                  9,904Sale
      of Excess Emission Allowances
                  
                  
                  -
                  
                  
                  
                  2,050Interest
      Received
                  
                  
                  8,657
                  
                  
                  
                  8,930Income
      Tax Refunds Received
                  
                  
                  6,566
                  
                  
                  
                  1,016Other
      Cash Receipts
                  
                  
                  4,147
                  
                  
                  
                  2,574Purchased
      Energy Costs Paid
                  
                  
                  (140,713
                  )
                  
                  
                  (132,549
                  )Fuel
      Costs Paid
                  
                  
                  (59,226
                  )
                  
                  
                  (61,829
                  )Payment
      of Other Operations and Maintenance Costs
                  
                  
                  (42,544
                  )
                  
                  
                  (35,698
                  )Taxes
      Other Than Income Taxes Paid, Net of Amounts Capitalized
                  
                  
                  (26,591
                  )
                  
                  
                  (25,432
                  )Wages
      Paid, Net of Amounts Capitalized
                  
                  
                  (34,265
                  )
                  
                  
                  (34,683
                  )Interest
      Paid, Net of Amounts Capitalized
                  
                  
                  (23,450
                  )
                  
                  
                  (25,368
                  )Capital
      Lease Interest Paid
                  
                  
                  (26,667
                  )
                  
                  
                  (32,504
                  )Income
      Taxes Paid
                  
                  
                  (7,400
                  )
                  
                  
                  (7,476
                  )Performance
      Deposits Payments
                  
                  
                  -
                  
                  
                  
                  (500
                  )Excess
      Tax Benefit from Stock Option Exercises
                  
                  
                  (135
                  )
                  
                  
                  (325
                  )Other
      Cash Payments
                  
                  
                  (1,378
                  )
                  
                  
                  (1,007
                  )Net
      Cash Flows - Operating Activities
                  
                  
                  54,596
                  
                  
                  
                  64,744Cash
      Flows from Investing ActivitiesCapital
      Expenditures
                  
                  
                  (90,261
                  )
                  
                  
                  (50,195
                  )Proceeds
      from Investment in Lease Debt and Equity
                  
                  
                  11,333
                  
                  
                  
                  11,206Other
      Proceeds from Investing Activities
                  
                  
                  821
                  
                  
                  
                  10Investments
      in Equity Investees
                  
                  
                  (66
                  )
                  
                  
                  (66
                  )Other
      Payments for Investing Activities
                  
                  
                  (612
                  )
                  
                  
                  (2,352
                  )Net
      Cash Flows - Investing Activities
                  
                  
                  (78,785
                  )
                  
                  
                  (41,397
                  )Cash
      Flows from Financing ActivitiesProceeds
      from Borrowings Under Revolving Credit Facilities
                  
                  
                  117,000
                  
                  
                  
                  91,000Proceeds
      from Issuance of Long-Term Debt
                  
                  
                  90,745
                  
                  
                  
                  -Proceeds
      from Stock Options Exercised
                  
                  
                  758
                  
                  
                  
                  495Excess
      Tax Benefit from Stock Option Exercises
                  
                  
                  135
                  
                  
                  
                  325Other
      Proceeds from Financing Activities
                  
                  
                  3,208
                  
                  
                  
                  2,396Repayments
      of Borrowings Under Revolving Credit Facilities
                  
                  
                  (109,000
                  )
                  
                  
                  (60,000
                  )Payments
      of Capital Lease Obligations
                  
                  
                  (62,153
                  )
                  
                  
                  (55,869
                  )Common
      Stock Dividends Paid
                  
                  
                  (8,497
                  )
                  
                  
                  (7,933
                  )Repayment
      of Long-Term Debt
                  
                  
                  (1,500
                  )
                  
                  
                  (1,500
                  )Payment
      of Debt Issue/Retirement Costs
                  
                  
                  (832
                  )
                  
                  
                  (114
                  )Other
      Payments for Financing Activities
                  
                  
                  (784
                  )
                  
                  
                  (2,060
                  )Net
      Cash Flows - Financing Activities
                  
                  
                  29,080
                  
                  
                  
                  (33,260
                  )Net
      Increase (Decrease) in Cash and Cash Equivalents
                  
                  
                  4,891
                  
                  
                  
                  (9,913
                  )Cash
      and Cash Equivalents, Beginning of Year
                  
                  
                  90,373
                  
                  
                  
                  104,241Cash
      and Cash Equivalents, End of Year
                  
                  $
                  95,264
                  
                  
                  $
                  94,328See Note 13
      for supplemental cash flow information.See Notes to
      Condensed Consolidated Financial Statements.
  4
 Table of Contents
  UNISOURCEENERGY CORPORATIONCOMPARATIVE
      CONDENSED CONSOLIDATED BALANCE SHEETSMarch
      31,
                  
                  
                  December
      31,2008
                  
                  
                  2007(Unaudited)ASSETS
                  
                  -
      Thousands of Dollars -Utility
      PlantPlant
      in Service
                  
                  $
                  3,595,287
                  
                  
                  $
                  3,565,735Utility
      Plant under Capital Leases
                  
                  
                  702,337
                  
                  
                  
                  702,337Construction
      Work in Progress
                  
                  
                  234,440
                  
                  
                  
                  195,105Total
      Utility Plant
                  
                  
                  4,532,064
                  
                  
                  
                  4,463,177Less
      Accumulated Depreciation and Amortization
                  
                  
                  (1,561,675
                  )
                  
                  
                  (1,534,424
                  )Less
      Accumulated Amortization of Capital Lease Assets
                  
                  
                  (527,836
                  )
                  
                  
                  (521,458
                  )Total
      Utility Plant - Net
                  
                  
                  2,442,553
                  
                  
                  
                  2,407,295Investments
      and Other PropertyInvestments
      in Lease Debt and Equity
                  
                  
                  140,972
                  
                  
                  
                  152,544Other
                  
                  
                  67,477
                  
                  
                  
                  70,677Total
      Investments and Other Property
                  
                  
                  208,449
                  
                  
                  
                  223,221Current
      AssetsCash
      and Cash Equivalents
                  
                  
                  95,264
                  
                  
                  
                  90,373Trade
      Accounts Receivable
                  
                  
                  110,462
                  
                  
                  
                  114,201Unbilled
      Accounts Receivable
                  
                  
                  44,479
                  
                  
                  
                  62,101Allowance
      for Doubtful Accounts
                  
                  
                  (18,738
                  )
                  
                  
                  (18,446
                  )Materials
      and Fuel Inventory
                  
                  
                  82,947
                  
                  
                  
                  82,433Energy
      Contracts - Derivative Assets
                  
                  
                  30,319
                  
                  
                  
                  5,489Income
      Taxes Receivable
                  
                  
                  25,856
                  
                  
                  
                  -Regulatory
      Assets - Other
                  
                  
                  9,680
                  
                  
                  
                  10,262Deferred
      Income Taxes - Current
                  
                  
                  35,186
                  
                  
                  
                  60,055Interest
      Receivable - Current
                  
                  
                  4,176
                  
                  
                  
                  9,450Other
                  
                  
                  16,703
                  
                  
                  
                  14,322Total
      Current Assets
                  
                  
                  436,334
                  
                  
                  
                  430,240Regulatory
      and Other AssetsTransition
      Recovery Regulatory Asset
                  
                  
                  6,695
                  
                  
                  
                  23,944Regulatory
      Asset - Income Taxes Recoverable Through Future Revenues
                  
                  
                  29,040
                  
                  
                  
                  30,009Regulatory
      Assets - Other
                  
                  
                  36,548
                  
                  
                  
                  37,313Energy
      Contracts - Derivative Assets
                  
                  
                  12,601
                  
                  
                  
                  8,339Other
      Assets
                  
                  
                  25,260
                  
                  
                  
                  25,355Total
      Regulatory and Other Assets
                  
                  
                  110,144
                  
                  
                  
                  124,960Total
      Assets
                  
                  $
                  3,197,480
                  
                  
                  $
                  3,185,716See Notes to
      Condensed Consolidated Financial Statements.(Consolidated
      Balance Sheets Continued)
  5
 Table of Contents
  UNISOURCE
      ENERGY CORPORATIONCOMPARATIVE
      CONDENSED CONSOLIDATED BALANCE SHEETSMarch
      31,
                  
                  
                  December
      31,2008
                  
                  
                  2007(Unaudited)CAPITALIZATION
      AND OTHER LIABILITIES
                  
                  -
      Thousands of Dollars -CapitalizationCommon
      Stock Equity
                  
                  $
                  685,735
                  
                  
                  $
                  690,075Capital
      Lease Obligations - Net of Current Obligations
                  
                  
                  514,387
                  
                  
                  
                  530,973Long-Term
      Debt - Net of Current Maturities
                  
                  
                  1,101,115
                  
                  
                  
                  993,870Total
      Capitalization
                  
                  
                  2,301,237
                  
                  
                  
                  2,214,918Current
      LiabilitiesCurrent
      Obligations under Capital Leases
                  
                  
                  20,758
                  
                  
                  
                  58,599Borrowing
      under Revolving Credit Facilities
                  
                  
                  -
                  
                  
                  
                  10,000Current
      Maturities of Long-Term Debt
                  
                  
                  204,300
                  
                  
                  
                  204,300Accounts
      Payable
                  
                  
                  97,229
                  
                  
                  
                  122,687Income
      Taxes Payable
                  
                  
                  -
                  
                  
                  
                  156Interest
      Accrued
                  
                  
                  19,491
                  
                  
                  
                  48,091Energy
      Contracts - Derivative Instruments
                  
                  
                  8,706
                  
                  
                  
                  3,193Accrued
      Taxes Other than Income Taxes
                  
                  
                  47,474
                  
                  
                  
                  36,775Accrued
      Employee Expenses
                  
                  
                  18,051
                  
                  
                  
                  24,585Customer
      Deposits
                  
                  
                  21,517
                  
                  
                  
                  21,425Regulatory
      Liabilities - Derivatives
                  
                  
                  15,689
                  
                  
                  
                  3,410Regulatory
      Liabilities - Over Recovered Purchased Gas Cost
                  
                  
                  6,153
                  
                  
                  
                  13,084Regulatory
      Liabilities - Other
                  
                  
                  160
                  
                  
                  
                  26Other
                  
                  
                  1,694
                  
                  
                  
                  1,350Total
      Current Liabilities
                  
                  
                  461,222
                  
                  
                  
                  547,681Deferred
      Credits and Other LiabilitiesDeferred
      Income Taxes - Noncurrent
                  
                  
                  152,489
                  
                  
                  
                  149,730Regulatory
      Liability - Net Cost of Removal for Interim Retirements
                  
                  
                  108,899
                  
                  
                  
                  106,695Regulatory
      Liabilities - Derivatives
                  
                  
                  9,038
                  
                  
                  
                  6,426Regulatory
      Liabilities - Other
                  
                  
                  9,852
                  
                  
                  
                  9,295Pension
      and Other Post-Retirement Benefits
                  
                  
                  76,919
                  
                  
                  
                  76,407Customer
      Advances for Construction
                  
                  
                  31,032
                  
                  
                  
                  28,798Energy
      Contracts - Derivative Instruments
                  
                  
                  6,027
                  
                  
                  
                  4,930Other
                  
                  
                  40,765
                  
                  
                  
                  40,836Total
      Deferred Credits and Other Liabilities
                  
                  
                  435,021
                  
                  
                  
                  423,117Commitments
      and Contingencies (Note 7)Total
      Capitalization and Other Liabilities
                  
                  $
                  3,197,480
                  
                  
                  $
                  3,185,716See Notes to
      Condensed Consolidated Financial Statements.(Consolidated
      Balance Sheets Concluded)
  6
 Table of Contents
  UNISOURCEENERGY
CORPORATIONCONDENSED
      CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY AND
      COMPREHENSIVE INCOMEAccumulatedCommon
                  
                  
                  
                  
                  
                  
                  
                  
                  Other
                  
                  
                  TotalShares
                  
                  
                  Common
                  
                  
                  Accumulated
                  
                  
                  Comprehensive
                  
                  
                  Stockholders'Outstanding*
                  
                  
                  Stock
                  
                  
                  Deficit
                  
                  
                  Loss
                  
                  
                  Equity(Unaudited)-Thousands of
      Dollars-Balances
      at December 31, 2007
                  
                  
                  35,315
                  
                  
                  $
                  702,368
                  
                  
                  $
                  (628
                  )
                  
                  $
                  (11,665
                  )
                  
                  $
                  690,075Impact of
      Change in Pension Plan Measurement Date
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (603
                  )
                  
                  
                  
                  
                  
                  
                  (603
                  )Comprehensive
      Income:2008
      Year-to-Date Net Loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (2,615
                  )
                  
                  
                  
                  
                  
                  
                  (2,615
                  )Unrealized
      Gain on Cash Flow Hedges(net of
      $3,628 income taxes)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  5,533
                  
                  
                  
                  5,533Reclassification
      of Unrealized Losses on Cash Flow
      Hedges to Net Income(net of $103
      income taxes)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  157
                  
                  
                  
                  157Employee
      Benefit Obligations
                    Amortization of net
      actuarial loss and prior
                    service creditincluded in
      net periodic benefit cost
                    (net of $30 income
      taxes)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (45
                  )
                  
                  
                  (45
                  )Total
      Comprehensive Income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  3,030Dividends
      Declared
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (8,497
                  )
                  
                  
                  
                  
                  
                  
                  (8,497
                  )Shares Issued
      under Stock Compensation Plans
                  
                  
                  22
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  -Shares Issued
      for Stock Options
                  
                  
                  44
                  
                  
                  
                  758
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  758Tax Benefit
      Realized from Stock Options Exercised
                  
                  
                  -
                  
                  
                  
                  135
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  135Other
                  
                  
                  -
                  
                  
                  
                  837
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  837Balances
      at March 31, 2008
                  
                  
                  35,381
                  
                  
                  $
                  704,098
                  
                  
                  $
                  (12,343
                  )
                  
                  $
                  (6,020
                  )
                  
                  $
                  685,735* UniSource
      Energy has 75 million authorized shares of Common Stock.See Notes to
      Condensed Consolidated Financial Statements.
  7
 Table of Contents
  TUCSONELECTRIC POWER COMPANYCOMPARATIVECONDENSED CONSOLIDATED
      STATEMENTS OF INCOME (LOSS)Three Months
      EndedMarch
      31,2008
                  
                  
                  2007(Unaudited)-Thousands of
      Dollars-Operating
      RevenuesElectric
      Retail Sales
                  
                  $
                  161,252
                  
                  
                  $
                  159,952Electric
      Wholesale Sales
                  
                  
                  52,313
                  
                  
                  
                  49,467Other
      Revenues
                  
                  
                  15,037
                  
                  
                  
                  10,210Total
      Operating Revenues
                  
                  
                  228,602
                  
                  
                  
                  219,629Operating
      ExpensesFuel
                  
                  
                  67,950
                  
                  
                  
                  61,080Purchased
      Power
                  
                  
                  32,221
                  
                  
                  
                  17,855Other
      Operations and Maintenance
                  
                  
                  60,623
                  
                  
                  
                  59,130Depreciation
      and Amortization
                  
                  
                  31,290
                  
                  
                  
                  29,062Amortization
      of Transition Recovery Asset
                  
                  
                  17,250
                  
                  
                  
                  14,986Taxes
      Other Than Income Taxes
                  
                  
                  10,549
                  
                  
                  
                  10,417Total
      Operating Expenses
                  
                  
                  219,883
                  
                  
                  
                  192,530Operating
      Income
                  
                  
                  8,719
                  
                  
                  
                  27,099Other
      Income (Deductions)Interest
      Income
                  
                  
                  2,788
                  
                  
                  
                  3,779Other
      Income
                  
                  
                  2,298
                  
                  
                  
                  686Other
      Expense
                  
                  
                  (1,013
                  )
                  
                  
                  (406
                  )Total
      Other Income (Deductions)
                  
                  
                  4,073
                  
                  
                  
                  4,059Interest
      ExpenseLong-Term
      Debt
                  
                  
                  11,712
                  
                  
                  
                  12,439Interest
      on Capital Leases
                  
                  
                  14,329
                  
                  
                  
                  16,146Other
      Interest Expense
                  
                  
                  1,005
                  
                  
                  
                  1,559Interest
      Capitalized
                  
                  
                  (1,056
                  )
                  
                  
                  (875
                  )Total
      Interest Expense
                  
                  
                  25,990
                  
                  
                  
                  29,269Income
      (Loss) Before Income Taxes
                  
                  
                  (13,198
                  )
                  
                  
                  1,889Income
      Tax Expense (Benefit)
                  
                  
                  (4,336
                  )
                  
                  
                  1,068Net
      Income (Loss)
                  
                  $
                  (8,862
                  )
                  
                  $
                  821See Notes to
      Condensed Consolidated Financial Statements.
  8
 Table of Contents
  TUCSON
      ELECTRIC POWER COMPANYCOMPARATIVECONDENSED CONSOLIDATED
      STATEMENTS OF CASH FLOWSThree Months
      Ended
                    March
      31,2008
                  
                  
                  2007(Unaudited)-Thousands of
      Dollars-Cash
      Flows from Operating ActivitiesCash
      Receipts from Electric Retail Sales
                  
                  $
                  187,776
                  
                  
                  $
                  188,194Cash
      Receipts from Electric Wholesale Sales
                  
                  
                  78,889
                  
                  
                  
                  95,079Cash
      Receipts from Operating Springerville Unit 3
                  
                  
                  13,490
                  
                  
                  
                  9,904Interest
      Received
                  
                  
                  8,035
                  
                  
                  
                  8,153Income
      Tax Refunds Received
                  
                  
                  6,140
                  
                  
                  
                  -Reimbursement
      of Affiliate Charges
                  
                  
                  5,480
                  
                  
                  
                  -Other
      Cash Receipts
                  
                  
                  1,814
                  
                  
                  
                  2,051Sale
      of Excess Emission Allowances
                  
                  
                  -
                  
                  
                  
                  2,050Fuel
      Costs Paid
                  
                  
                  (59,226
                  )
                  
                  
                  (61,829
                  )Purchased
      Power Costs Paid
                  
                  
                  (58,217
                  )
                  
                  
                  (59,164
                  )Payment
      of Other Operations and Maintenance Costs
                  
                  
                  (41,043
                  )
                  
                  
                  (32,362
                  )Capital
      Lease Interest Paid
                  
                  
                  (26,659
                  )
                  
                  
                  (32,498
                  )Wages
      Paid, Net of Amounts Capitalized
                  
                  
                  (28,482
                  )
                  
                  
                  (28,450
                  )Taxes
      Other Than Income Taxes Paid, Net of Amounts Capitalized
                  
                  
                  (17,474
                  )
                  
                  
                  (16,568
                  )Interest
      Paid, Net of Amounts Capitalized
                  
                  
                  (14,149
                  )
                  
                  
                  (15,735
                  )Income
      Taxes Paid
                  
                  
                  -
                  
                  
                  
                  (8,375
                  )Other
      Cash Payments
                  
                  
                  (853
                  )
                  
                  
                  (728
                  )Net
      Cash Flows - Operating Activities
                  
                  
                  55,521
                  
                  
                  
                  49,722Cash
      Flows from Investing ActivitiesCapital
      Expenditures
                  
                  
                  (73,700
                  )
                  
                  
                  (34,499
                  )Proceeds
      from Investments in Lease Debt and Equity
                  
                  
                  11,333
                  
                  
                  
                  11,206Other
      Proceeds from Investing Activities
                  
                  
                  5
                  
                  
                  
                  -Other
      Payments for Investing Activities
                  
                  
                  (612
                  )
                  
                  
                  (2,304
                  )Net
      Cash Flows - Investing Activities
                  
                  
                  (62,974
                  )
                  
                  
                  (25,597
                  )Cash
      Flows from Financing ActivitiesProceeds
      from Issuance of Long-Term Debt
                  
                  
                  90,745
                  
                  
                  
                  -Proceeds
      from Borrowings Under Revolving Credit Facility
                  
                  
                  90,000
                  
                  
                  
                  85,000Repayments
      of Borrowings Under Revolving Credit Facility
                  
                  
                  (100,000
                  )
                  
                  
                  (40,000
                  )Payments
      of Capital Lease Obligations
                  
                  
                  (62,137
                  )
                  
                  
                  (55,854
                  )Other
      Proceeds from Financing Activities
                  
                  
                  254
                  
                  
                  
                  764Payment
      of Debt Issue Costs
                  
                  
                  (816
                  )
                  
                  
                  -Other
      Payments for Financing Activities
                  
                  
                  (178
                  )
                  
                  
                  (404
                  )Net
      Cash Flows - Financing Activities
                  
                  
                  17,868
                  
                  
                  
                  (10,494
                  )Net
      Increase in Cash and Cash Equivalents
                  
                  
                  10,415
                  
                  
                  
                  13,631Cash
      and Cash Equivalents, Beginning of Year
                  
                  
                  26,610
                  
                  
                  
                  19,711Cash
      and Cash Equivalents, End of Year
                  
                  $
                  37,025
                  
                  
                  $
                  33,342See Note 13
      for supplemental cash flow information.See Notes to
      Condensed Consolidated Financial Statements.
  9
 Table of Contents
  TUCSONELECTRIC POWER COMPANYCOMPARATIVE
      CONDENSED CONSOLIDATED BALANCE SHEETSMarch
      31,
                  
                  
                  December
      31,2008
                  
                  
                  2007(Unaudited)ASSETS
                  
                  -
      Thousands of Dollars -Utility
      PlantPlant
      in Service
                  
                  $
                  3,164,560
                  
                  
                  $
                  3,143,823Utility
      Plant under Capital Leases
                  
                  
                  701,631
                  
                  
                  
                  701,631Construction
      Work in Progress
                  
                  
                  154,457
                  
                  
                  
                  123,833Total
      Utility Plant
                  
                  
                  4,020,648
                  
                  
                  
                  3,969,287Less
      Accumulated Depreciation and Amortization
                  
                  
                  (1,513,370
                  )
                  
                  
                  (1,490,724
                  )Less
      Accumulated Amortization of Capital Lease Assets
                  
                  
                  (527,412
                  )
                  
                  
                  (521,057
                  )Total
      Utility Plant - Net
                  
                  
                  1,979,866
                  
                  
                  
                  1,957,506Investments
      and Other PropertyInvestments
      in Lease Debt and Equity
                  
                  
                  140,972
                  
                  
                  
                  152,544Other
                  
                  
                  32,423
                  
                  
                  
                  35,460Total
      Investments and Other Property
                  
                  
                  173,395
                  
                  
                  
                  188,004Current
      AssetsCash
      and Cash Equivalents
                  
                  
                  37,025
                  
                  
                  
                  26,610Trade
      Accounts Receivable
                  
                  
                  83,791
                  
                  
                  
                  90,747Unbilled
      Accounts Receivable
                  
                  
                  27,833
                  
                  
                  
                  35,941Allowance
      for Doubtful Accounts
                  
                  
                  (16,513
                  )
                  
                  
                  (16,538
                  )Intercompany
      Accounts Receivable
                  
                  
                  8,323
                  
                  
                  
                  8,740Materials
      and Fuel Inventory
                  
                  
                  73,420
                  
                  
                  
                  72,732Income
      Taxes Receivable
                  
                  
                  29,958
                  
                  
                  
                  8,070Current
      Regulatory Assets
                  
                  
                  9,680
                  
                  
                  
                  9,554Deferred
      Income Taxes - Current
                  
                  
                  34,543
                  
                  
                  
                  59,157Interest
      Receivable - Current
                  
                  
                  4,117
                  
                  
                  
                  9,383Energy
      Contracts - Derivative Assets
                  
                  
                  13,078
                  
                  
                  
                  2,036Other
                  
                  
                  15,192
                  
                  
                  
                  13,062Total
      Current Assets
                  
                  
                  320,447
                  
                  
                  
                  319,494Regulatory
      and Other AssetsTransition
      Recovery Regulatory Asset
                  
                  
                  6,695
                  
                  
                  
                  23,945Regulatory
      Asset - Income Taxes Recoverable Through Future Revenues
                  
                  
                  29,040
                  
                  
                  
                  30,009Regulatory
      Assets - Other
                  
                  
                  33,634
                  
                  
                  
                  34,123Energy
      Contracts - Derivative Assets
                  
                  
                  2,349
                  
                  
                  
                  492Other
      Assets
                  
                  
                  19,573
                  
                  
                  
                  19,463Total
      Regulatory and Other Assets
                  
                  
                  91,291
                  
                  
                  
                  108,032Total
      Assets
                  
                  $
                  2,564,999
                  
                  
                  $
                  2,573,036See Notes to
      Condensed Consolidated Financial Statements.(Consolidated
      Balance Sheets Continued)
  10
 Table of Contents
  TUCSON
      ELECTRIC POWER COMPANYCOMPARATIVE
      CONDENSED CONSOLIDATED BALANCE SHEETSMarch
      31,
                  
                  
                  December
      31,2008
                  
                  
                  2007(Unaudited)CAPITALIZATION
      AND OTHER LIABILITIES
                  
                  -
      Thousands of Dollars -CapitalizationCommon
      Stock Equity
                  
                  $
                  572,591
                  
                  
                  $
                  577,349Capital
      Lease Obligations - Net of Current Obligations
                  
                  
                  514,160
                  
                  
                  
                  530,714Long-Term
      Debt - Net of Current Maturities
                  
                  
                  773,615
                  
                  
                  
                  682,870Total
      Capitalization
                  
                  
                  1,860,366
                  
                  
                  
                  1,790,933Current
      LiabilitiesCurrent
      Obligations under Capital Leases
                  
                  
                  20,661
                  
                  
                  
                  58,502Current
      Maturities of Long-Term Debt
                  
                  
                  138,300
                  
                  
                  
                  138,300Borrowing
      Under Revolving Credit Facility
                  
                  
                  -
                  
                  
                  
                  10,000Accounts
      Payable
                  
                  
                  66,778
                  
                  
                  
                  87,599Intercompany
      Accounts Payable
                  
                  
                  5,134
                  
                  
                  
                  4,512Interest
      Accrued
                  
                  
                  17,400
                  
                  
                  
                  41,394Accrued
      Taxes Other than Income Taxes
                  
                  
                  37,371
                  
                  
                  
                  28,690Accrued
      Employee Expenses
                  
                  
                  16,172
                  
                  
                  
                  22,557Energy
      Contracts - Derivative Liabilities
                  
                  
                  8,330
                  
                  
                  
                  2,460Other
                  
                  
                  16,097
                  
                  
                  
                  15,533Total
      Current Liabilities
                  
                  
                  326,243
                  
                  
                  
                  409,547Deferred
      Credits and Other LiabilitiesDeferred
      Income Taxes - Noncurrent
                  
                  
                  165,313
                  
                  
                  
                  163,834Regulatory
      Liability - Net Cost of Removal for Interim Retirements
                  
                  
                  88,928
                  
                  
                  
                  87,311Pension
      and Other Post-Retirement Benefits
                  
                  
                  73,318
                  
                  
                  
                  72,755Energy
      Contracts - Derivative Liabilities
                  
                  
                  5,398
                  
                  
                  
                  3,278Other
                  
                  
                  45,433
                  
                  
                  
                  45,378Total
      Deferred Credits and Other Liabilities
                  
                  
                  378,390
                  
                  
                  
                  372,556Commitments
      and Contingencies (Note 7)Total
      Capitalization and Other Liabilities
                  
                  $
                  2,564,999
                  
                  
                  $
                  2,573,036See Notes to
      Condensed Consolidated Financial Statements.(Consolidated
      Balance Sheets Concluded)
  11
 Table of Contents
  TUCSONELECTRIC POWER
COMPANYCONDENSED
      CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER'S EQUITY AND
      COMPREHENSIVE INCOMEAccumulatedCapital
                  
                  
                  
                  
                  
                  Other
                  
                  
                  TotalCommon
                  
                  
                  Stock
                  
                  
                  Accumulated
                  
                  
                  Comprehensive
                  
                  
                  Stockholder'sStock
                  
                  
                  Expense
                  
                  
                  Deficit
                  
                  
                  Loss
                  
                  
                  Equity(Unaudited)- Thousands
      of Dollars -Balances
      at December 31, 2007
                  
                  $
                  813,971
                  
                  
                  $
                  (6,357
                  )
                  
                  $
                  (218,488
                  )
                  
                  $
                  (11,777
                  )
                  
                  $
                  577,349Impact of
      Change in Pension Plan Measurement Date
                  
                  
                  
                  
                  
                  
                  
                  (526
                  )
                  
                  
                  
                  
                  
                  
                  (526
                  )Comprehensive
      Income:2008
      Year-to-Date Net Loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (8,862
                  )
                  
                  
                  -
                  
                  
                  
                  (8,862
                  )Unrealized
      Gain on Cash Flow Hedges(net of $2,928 income taxes)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  4,466
                  
                  
                  
                  4,466Reclassification
      of Unrealized Losses on Cash Flow Hedges to Net Income(net of $137
      income taxes)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  209
                  
                  
                  
                  209Employee
      Benefit ObligationsAmortization of net actuarial loss and prior
      service credit included in net periodic benefit costs(net of $30
      income taxes)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (45
                  )
                  
                  
                  (45
                  )Total
      Comprehensive Loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (4,232
                  )Balances
      at March 31, 2008
                  
                  $
                  813,971
                  
                  
                  $
                  (6,357
                  )
                  
                  $
                  (227,876
                  )
                  
                  $
                  (7,147
                  )
                  
                  $
                  572,591See Notes to
      Condensed Consolidated Financial Statements.
  12
 Table of Contents
  NOTESTO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - Unaudited
  NOTE1.  NATURE OF OPERATIONS AND BASIS OF ACCOUNTING
PRESENTATION
 
 UniSource Energy
Corporation (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 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, is UniSource Energy’s largest operating subsidiary and
represented approximately 80% of UniSource Energy’s assets as of March 31,
2008.  TEP generates, transmits and distributes electricity to
approximately 398,000 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.  In
addition, TEP operates Springerville Unit 3 on behalf of Tri-State Generation
and Transmission Association, Inc. (Tri-State).
 
 UES holds the
common stock of UNS Gas, Inc. (UNS Gas) and UNS Electric, Inc. (UNS
Electric).  UNS Gas is a gas distribution company with 146,000 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 with approximately 90,000 retail
customers in Mohave and Santa Cruz counties.
 
 Millennium invests
in unregulated energy related businesses.
 
 UED is developing
the Black Mountain Generating Station (BMGS), a 90 MW gas turbine project in
Northern Arizona that, subject to FERC approval, is expected to provide energy
to 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 2007 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.  To be comparable with the 2008 presentation, UNS and TEP
reclassified in the prior year financial statements less than $0.5 million, from
Other Income to Interest Income.  This reclassification had no effect
on Net Income.
 
 NOTE2.  REGULATORY MATTERS
 
 ACCOUNTING
FOR RATE REGULATION
 
 TEP, UNS Gas and
UNS Electric generally use the same accounting policies and practices used by
unregulated companies.  Sometimes these principles, such as 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, 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 they charge these expenses 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 they are allowed to charge their customers.  TEP, UNS Gas
and UNS Electric then amortize these items as expense as they recover these
charges 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.
  13
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  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 the specific costs of providing service;
      and
 ·
                  the service
      territory lacks competitive pressures to reduce rates below the rates set
      by the regulator.
 TEP
1999 Settlement Agreement
 
 In
1999, the ACC approved the Rules for the introduction of retail electric
competition in Arizona, as well as the 1999 Settlement Agreement between TEP and
certain customer groups related to the implementation of retail electric
competition in Arizona.
 
 The Rules and the
1999 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); and
 ·
                  transmission
      and distribution services would remain subject to regulation on a cost of
      service basis.
 We believe that the
1999 Settlement Agreement provides that the price TEP charges its retail
customers for generation be market-based and its retail customers should begin
paying the market rate for generation services beginning on January 1,
2009.  However, the company is in the process of a rate proceeding to
determine customer rates in 2009.  See 2008 Proposed Settlement
Agreement discussed below.
 
 Upon approval of
the 1999 Settlement Agreement, which introduced electric retail competition in
Arizona, TEP discontinued regulatory accounting under FAS 71 for its generation
operations.  TEP continues to apply FAS 71 to its transmission and
distribution operations.
 
 In
June 2004, as required by the 1999 Settlement Agreement, TEP filed general rate
case information with the ACC.  While TEP’s filing did not propose any
change in retail rates, the filing, with a test year ended December 31, 2003,
showed that TEP was experiencing a revenue deficiency of $111 million,
reflecting the need for an increase in retail rates of 16%.
 
 TEP
Rate Proposal Filing
 
 In
April 2006, the ACC ordered that a procedure be established to allow for a
review of:
 ·
                  the 1999
      Settlement Agreement and its effect on how TEP’s rates for generation
      services will be determined after December 31,
  2008;
 ·
                  TEP’s
      proposed amendments to the 1999 Settlement Agreement;
  and
 ·
                  Demand-Side
      Management (DSM), Renewable Energy Standards Tariffs (REST), and Time of
      Use Tariffs (TOU).
 In July 2007, as
required by the ACC, TEP filed the following rate proposal methodologies to
establish new retail rates for TEP beginning in January 2009:
  (1)
                  Market-based
      generation and cost of service for transmission and distribution, showing
      a revenue deficiency of $172 million, reflecting an overall increase of
      approximately 22% over current retail
rates.
  14
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
 (2)
                  Cost-of-service
      for generation, transmission and distribution showing a revenue deficiency
      of $181 million, reflecting an overall increase of approximately 23% over
      current retail rates.
 (3)
                  Hybrid
      methodology with cost of service for generation, transmission and
      distribution. However, certain generation assets would be excluded from
      cost of service, showing a revenue deficiency of $117 million, reflecting
      an overall increase of approximately 15% over current retail
      rates.
  2008 Proposed Settlement
Agreement
 
 TEP and ACC Staff
have agreed in principle to the major terms of a settlement in the TEP rate
proceeding.  TEP and the ACC Staff will commence the process of
preparing a definitive settlement agreement, which is expected to be filed with
the ACC.  There can be no assurance that a definitive settlement
agreement will be reached or whether other participants in the rate proceeding
will support the proposed settlement.  The proposed rates will be more
fully developed in connection with the preparation of a definitive settlement
agreement and may vary from those described below. A settlement agreement would
also be subject to a hearing before the administrative law judge and approval by
the ACC.
 
 As
currently contemplated, the settlement would provide for a cost of service rate
methodology for TEP’s generation assets; a base rate increase of 6% over TEP’s
current retail rates; the fuel rate included in base rates would be 2.9 cents
per kilowatt-hour (kWh); a PPFAC effective January 1, 2009; a base rate
moratorium through January 1, 2013; and a waiver of any claims under the 1999
Settlement Agreement.
 
 The settlement
contemplates that the ACC would establish the date that the base rate increase
would go into effect.
 
 TEP cannot predict
the outcome of the rate case proceeding.
 As
the 2008 proposed settlement agreement provides for a cost of service
methodology, TEP is analyzing the implications of potentially reapplying FAS 71
for its generation operations.
 
 Renewable
Energy Standard and Tariff (REST)
 
 In
April 2008, the ACC approved a REST plan for TEP.  As a result, TEP
will collect $14 million from customers annually, beginning June 1,
2008.  The funds received from customers under the REST plan will be
recognized as revenue in the income statement, and will be used to offset the
incremental cost of renewable power generated or purchased by TEP, and the
program administrative and marketing costs.  The REST program will not
impact TEP’s net income.
 
 Future
Implications of Discontinuing Application of FAS 71
 
 TEP continues to
apply FAS 71 to its regulated operations, which include the transmission and
distribution portions of its business.  TEP regularly assesses whether
it can continue to apply FAS 71 to these 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 recognize its
regulatory liabilities as income on its income statement.  Based on
the regulatory asset balances, net of regulatory liabilities, at March 31, 2008,
if TEP had stopped applying FAS 71 to its remaining regulated operations, it
would have recorded an extraordinary after-tax gain of approximately $6
million.  While regulatory orders and market conditions may affect
cash flows, TEP’s cash flows would not be affected if we stopped applying FAS
71.
 
 Transition
Recovery Asset
 
 TEP will amortize
the remaining Transition Recovery Asset balance as costs are recovered through
rates until TEP has recovered $450 million of transition costs.  At
March 31, 2008 and December 31, 2007, the Transition Recovery balance was $7
million and $24 million, respectively.  It is expected that by May 31,
2008, the TRA will be fully amortized and have no further impact on net
income.
 
 In
May 2007, the ACC ordered that TEP’s current Standard Offer rates shall remain
at their current level, including continued collection of the Fixed Competition
Transition Charge (Fixed CTC) ($0.009 per kWh), until the effective date of a
final order in the TEP rate proposal proceeding.  The incremental
income collected as a result of retaining the true-up revenue after it would
otherwise terminate (CTC True-Up Revenue) shall accrue interest and shall be
recorded as deferred revenue.  The treatment of the deferred revenue
will be determined when the TEP rate case is finalized.
  15
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
 The 2008 proposed
settlement agreement does not address the amount or the treatment of any CTC
True-Up Revenues, but would provide, to the extent the ACC determines that the
true-up revenues are to be credited to customers, that TEP will credit up to
$32.5 million of true-up revenues to customers through the PPFAC.
 
 UNS
GAS RATES AND REGULATION
 
 2008
General Rate Case Filing
 
 In
February 2008, UNS Gas filed a general rate case with the ACC, (on a cost of
service basis), requesting a total increase of 7% to cover a revenue deficiency
of $10 million.
 
 In
March 2008, ACC Staff informed UNS Gas that the historical test year used in its
general rate case filing did not meet ACC requirements and, as a result, the
filing by UNS Gas was deficient.  UNS Gas is seeking resolution of
this issue, but can not predict when or if the ACC will reconsider its
position.
 
 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.  All purchased gas commodity
costs, including transportation, increase the PGA bank, a balancing
account.  UNS Gas recovers these costs or returns amounts
over-collected from/to ratepayers through a PGA mechanism.  The PGA
mechanism includes the following two components:
 
 (1)
                The PGA factor, computed
      monthly, is a calculation of the twelve-month rolling weighted average gas
      cost, and automatically adjusts monthly, subject to limitations on how
      much the price per therm may change in a twelve month
      period.  Effective December 2007, the ACC increased the annual
      cap on the maximum increase in the PGA factor from $0.10 per therm to
      $0.15 per therm in a twelve month
period.
 
 (2)
                At any time
      UNS Gas’ PGA bank balance is under-recovered, UNS Gas may request a PGA surchargewith the
      goal of collecting the amount deferred from customers over a period deemed
      appropriate by the ACC.  When the PGA bank balance reaches an
      over-collected balance of $10 million on a billed basis, UNS Gas is
      required to request a PGA
      surcreditwith the goal of returning the over-collected balance to
      customers over a period deemed appropriate by the ACC.  Prior to
      December 2007, the designated under-or over-recovery trigger points were
      $6.2 million and $4.5 million,
respectively.
 
 The PGA surcharge
in 2007 was $0.05 cents per therm through April 2007.  In September
2007, the ACC approved a $0.04 cent per therm PGA credit, effective October 2007
through April 2008.
 
 Based on current
projections of gas prices, UNS Gas believes that the surcredit amount will still
allow it to timely recover its gas costs.   However, changes in
the market price for gas, sales volumes and surcharge amount could significantly
change the PGA bank balance in the future.
 
 At
March 31, 2008, UNS Gas had over recovered its costs by $6 million on an accrual
(GAAP) basis of which $1 million was on a billed basis.  At December
31, 2007, UNS Gas had over recovered its costs by $13 million on an accrual
(GAAP) basis of which $3 million was on a billed basis.  The balance
is shown on the balance sheet as Regulatory Liabilities - Over Recovered
Purchased Gas Costs.
 
 Future
Implications of Discontinuing Application of FAS 71
 
 UNS Gas regularly
assesses whether it can continue to apply FAS 71 to its regulated
operations.  If UNS Gas stopped applying FAS 71, UNS Gas would
write-off the related balance of its regulatory assets as an expense and
write-off its regulatory liabilities as income on its income
statement.  Based on the regulatory asset and liability balances, if
UNS Gas had stopped applying FAS 71, UNS Gas would have recorded an
extraordinary after-tax gain of $14 million at March 31,
2008.  Discontinuing application of FAS 71 would not affect UNS Gas’
cash flows.
  16
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  UNS
ELECTRIC RATES AND REGULATION
 
 General
Rate Case Filing
 
 In
December 2006, UNS Electric filed a general rate case (on a cost of service
basis) with the ACC requesting a rate increase of 5.5% to cover a base rate
revenue deficiency of $9 million.  The increase is necessary due to
the growth in UNS Electric’s service territory and related increases in capital
expenditures and operating costs.
 
 UNS Electric
requested that a new PPFAC mechanism take effect when the current power supply
agreement with PWMT expires in May 2008.
 
 UNS Electric has
also requested, as part of its rate case, that the ACC approve the transfer of
the 90 MW BMGS from UED to UNS Electric.  Because BMGS was not in
service during the test year of UNS Electric’s rate case, the Administrative Law
Judge (ALJ) recommended against this rate treatment.  As a contingency
plan, in the event that the ACC doesn’t approve the request, UED and UNS
Electric have entered into a Power Purchase and Sales Agreement (PPA) pursuant
to which UED would sell all the output of BMGS to UNS Electric over a five-year
term.  The PPA, which is subject to FERC approval, is a tolling
arrangement in which UNS Electric takes operational control of BMGS and assumes
all risk of operation and maintenance costs, including fuel.  Under
the terms of the PPA, UNS Electric would pay UED $0.9 million per month as a
capacity charge.  See Note 7.
 
 On
April 24, 2008, the ALJ presiding over UNS Electric’s rate case proceeding
issued a recommended opinion and order, in which the ACC authorized UNS Electric
to defer the costs associated with the PPA until they are addressed as part of
UNS Electric’s pending general rate case.  The ALJ has recommended
that UNS Electric’s costs under the PPA be recovered through UNS Electric’s
PPFAC.  UNS Electric expects FERC to issue an order in May
2008.
 
 The ALJ recommended
a revenue increase of $4 million compared with UNS Electric’s request of $9
million.  The recommendation also included a 9% return on an original
rate base cost of $131 million.  UNS Electric had requested a 9.9%
return on an original rate base cost of $141 million.  The ALJ
recommendation denied UNS Electric’s request to include BMGS in rate
base.
 
 The ALJ recommended
that the new UNS Electric’s rates take effect June 1, 2008 and the ACC is
expected to consider the ALJ’s recommendation and issue a final order in May
2008.
 
 UNS Electric has
deferred $0.6 million of rate case preparation costs as a regulatory asset on
its balance sheet.  As part of the UNS Electric rate case opinion, the
ALJ recommended recovery of only $0.3 million for rate case
costs.  UNS Electric is contesting the disallowance of the costs and
believes the $0.6 million is probable of recovery.  However, should
the final ACC order provide for recovery of less than $0.6 million, UNS Electric
would immediately expense the difference between the $0.6 million recorded and
the recoverable amount.
 
 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 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 PWMT.
 
 As
part of the general rate case filing, UNS Electric requested and the ALJ
recommended that a new PPFAC mechanism take effect beginning June 1, 2008,
immediately following the expiration of the current power supply agreement with
PWMT, that would utilize a forward looking projection of gas and purchased power
costs.
 
 At
March 31, 2008, UNS Electric had over recovered its purchased power by $10
million on an accrual (GAAP) basis of which $6 million was on a billed
basis.  At December 31, 2007, UNS Electric had over recovered its
purchased power by $9 million on an accrual (GAAP) basis of which $4 million was
on a billed basis. The PPFAC balance is shown on the balance sheet as Regulatory
Liabilities - Other.
 
 17
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  Renewable
Energy Standard and Tariff (REST)
 
 In
April 2008, the ACC approved a REST plan for UNS Electric.  As a
result, UNS Electric will collect $3 million from customers annually, beginning
June 1, 2008.  The funds received from customers under the REST plan
which will be recognized as revenue in the income statement and will be used to
offset the incremental cost of renewable power generated or purchased by UNS
Electric and the program administrative and marketing costs.  The REST
program will not impact UNS Electric’s net income.
 
 Future
Implications of Discontinuing Application of FAS 71
 
 UNS Electric
regularly assesses whether it can continue to apply FAS 71 to its regulated
operations.  If UNS Electric stopped applying FAS 71, it would
write-off the related balances of their regulatory assets as an expense and
would write-off its regulatory liabilities as income on their income
statement.  Based on the regulatory asset and liability balances, if
UNS Electric had stopped applying FAS 71, it would have recorded an
extraordinary after-tax gain of $21 million at March 31,
2008.  Discontinuing application of FAS 71 would not affect UNS
Electric’s cash flows.
 
 NOTE3.  DEBT AND CREDIT FACILITIES
 
 TEP
Letter of Credit Facility
 
 On
April 30, 2008, TEP entered into a three-year $133 million letter of credit
facility.  The TEP Letter of Credit Facility will support up to $130
million of variable rate tax-exempt bonds that TEP expects to issue in June or
July of 2008.  As of May 9, 2008, the letter of credit under the TEP
Letter of Credit Facility was not issued.
 
 Interest rates and
fees under the TEP Letter of Credit Facility are based on a pricing grid tied to
TEP’s credit ratings.  Letter of credit fees are 0.75% per annum
during the first two years and 0.875% in the third year.  TEP will
also pay a commitment fee of 0.11% per annum during the first two
years.
 
 The TEP Letter of
Credit Facility restricts additional indebtedness, liens, sale of assets and
sale-leaseback agreements.  The TEP Letter of Credit Facility also
requires TEP to meet a minimum cash coverage ratio and a maximum leverage
ratio.  If TEP complies with the terms of the TEP Letter of Credit
Facility, it may pay dividends to UniSource Energy.
 
 If
an event of default occurs, the TEP Credit Agreement may become immediately due
and payable.  An event of default includes failure to make required
payments under the TEP Credit Agreement; change in control, as defined; failure
of TEP or certain subsidiaries to make payments or default on debt greater than
$20 million; or certain bankruptcy events at TEP or certain
subsidiaries.
 
 TEP
Long Term Debt
 
 In
March 2008, The Industrial Development Authority of Pima County issued for the
benefit of TEP approximately $91 million, of its 2008 Series A tax-exempt,
unsecured, unsubordinated 6.375% bonds, (2008 Pima A Bonds) due September
2029.  The proceeds were used to redeem a corresponding principal
amount of bonds previously issued by the Pima Authority for TEP’s benefit which
TEP repurchased in 2005.  TEP did not cancel the repurchased bonds,
which remained outstanding under their respective indentures but were not
reflected as debt on the balance sheet.  As holder of the repurchased
bonds, TEP received the payment of the redemption price.
 
 TEP used the
redemption proceeds to repay $75 million in revolving loans outstanding under
its revolving credit facility.  The remaining proceeds will be used,
in May 2008, to redeem $10 million of the $138 million, 7.5% Collateral Trust
Bonds due August 2008.  TEP capitalized $1 million of costs related to
the issuance of the 2008 Pima A Bonds and will amortize these costs through
August 2029, the term of the bonds.
 
 Interest on the
2008 Pima A Bonds is payable semi-annually, commencing on September 1,
2008.
 
 Beginning on March
1, 2013, TEP will have the option to redeem the 2008 Pima A Bonds, in whole or
in part, for cash, at a price equal to 100% of the principal amount, plus
accrued interest.
 
 18
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  TEP
CREDIT AGREEMENT
 
 At
March 31, 2008, TEP had no borrowings outstanding and  $5 million in
letters of credit issued under its revolving credit agreement.  As of
December 31, 2007, TEP had no borrowings outstanding and $10 million in letters
of credit outstanding under its revolving credit facility.
 
 UNS
GAS/UNS ELECTRIC REVOLVING CREDIT AGREEMENT
 
 The borrowings
under the UNS Gas/UNS Electric Revolver were as follows:
 
 UNS
                    Gas
                  
                  
                  UNS
                    Electric
                  
                  
                  UNS
                    Gas
                  
                  
                  UNS
                    ElectricMarch
      31, 2008
                  
                  
                  December 31,
      2007-Millions
      of Dollars-Balance
      on the Revolver
                  
                  $
                  -
                  
                  
                  $
                  30
                  
                  
                  $
                  -
                  
                  
                  $
                  26Outstanding
      Letters of Credit
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  10
                  
                  
                  $
                  -
  At
March 31, 2008 and December 31, 2007, UNS Electric’s borrowings under the UNS
Gas/UNS Electric Revolver were excluded from Current Liabilities and presented
as Long-Term Debt, as UNS Electric has the ability and the intent to have
outstanding borrowings under the UNS Gas/UNS Electric Revolver respective
revolving credit facilities for the next twelve months.
 
 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.
 
 The UniSource
Energy, UES and Millennium holding companies, UED, and several other
subsidiaries and equity investments, which are not considered reportable
segments, are included in Other.  Through affiliates, Millennium holds
investments in several unregulated energy and emerging technology
companies.  UED develops generating resources and performs other
project development activities.
 
 Reconciling
adjustments consist of the elimination of the following intercompany activity
and balances:
  ·
                  Intercompany
      activity between UniSource Energy and
UED.
 ·
                  SES, a
      Millennium subsidiary, recorded revenue from transactions with TEP, UNS
      Electric and UNS Gas of $4 million for the three months ended March 31,
      2008 and $4 million for the three months ended March 31,
      2007.  The related expense is reported in Other Operations and
      Maintenance expense on the consolidated income
      statement.  Millennium’s revenue and the related expense are
      eliminated in UniSource Energy
consolidation.
 ·
                  TEP recorded
      revenue from providing support services to UNS Gas and UNS Electric of $2
      million for the three months ended March 31, 2008 and $1 million for the
      three months ended March 31, 2007.  UNS Gas’ and UNS Electric’s
      related expense is reported in Other Operations and Maintenance expense on
      the consolidated income statement.  TEP’s revenue and the
      related expenses in UNS Gas and UNS Electric are eliminated in UniSource
      Energy consolidation.
 ·
                  Other
      significant reconciling adjustments include the elimination of investments
      in subsidiaries held by UniSource Energy and reclassifications of deferred
      tax assets and liabilities.
 19
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  We disclose
selected financial data for our reportable segments in the following
table:
  Reportable
      Segments
                  
                  
                  
                  
                  
                  
                  
                  
                  UniSourceTEP
                  
                  
                  UNS
                    Gas
                  
                  
                  UNS
                    Electric
                  
                  
                  Other
                  
                  
                  Reconciling
                    Adjustments
                  
                  
                  Energy
                    ConsolidatedIncome
      Statement
                  
                  -Millions of
      Dollars-Three
      months ended March 31, 2008:Operating Revenues -
      External
                  
                  $
                  227
                  
                  
                  $
                  66
                  
                  
                  $
                  37
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  330Operating Revenues -
      Intersegment
                  
                  
                  2
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  4
                  
                  
                  
                  (6
                  )
                  
                  
                  -Income (Loss) Before Income
      Taxes
                  
                  
                  (13
                  )
                  
                  
                  10
                  
                  
                  
                  1
                  
                  
                  
                  (1
                  )
                  
                  
                  -
                  
                  
                  
                  (3
                  )Net Income (Loss)
                  
                  $
                  (9
                  )
                  
                  $
                  6
                  
                  
                  $
                  1
                  
                  
                  $
                  (1
                  )
                  
                  $
                  -
                  
                  
                  $
                  (3
                  )Three
      months ended March 31, 2007:Operating Revenues -
      External
                  
                  $
                  219
                  
                  
                  $
                  63
                  
                  
                  $
                  36
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  318Operating Revenues -
      Intersegment
                  
                  
                  1
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  4
                  
                  
                  
                  (5
                  )
                  
                  
                  -Income (Loss) Before Income
      Taxes
                  
                  
                  2
                  
                  
                  
                  8
                  
                  
                  
                  1
                  
                  
                  
                  (2
                  )
                  
                  
                  -
                  
                  
                  
                  9Net Income (Loss)
                  
                  $
                  1
                  
                  
                  $
                  5
                  
                  
                  $
                  -
                  
                  
                  $
                  (1
                  )
                  
                  $
                  -
                  
                  
                  $
                  5Balance
      SheetTotal Assets, March 31,
      2008
                  
                  $
                  2,565
                  
                  
                  $
                  272
                  
                  
                  $
                  241
                  
                  
                  $
                  1,087
                  
                  
                  $
                  (968
                  )
                  
                  $
                  3,197Total Assets, December 31,
      2007
                  
                  $
                  2,573
                  
                  
                  $
                  276
                  
                  
                  $
                  226
                  
                  
                  $
                  1,077
                  
                  
                  $
                  (966
                  )
                  
                  $
                  3,186
  NOTE5.  ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND TRADING
ACTIVITIES
 
 FUEL
AND POWER TRANSACTIONS
 
 TEP, UNS Gas and
UNS Electric enter 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.  TEP, UNS Gas and UNS Electric
have natural gas supply agreements under which each company purchases all of its
gas requirements at spot market prices.  In an effort to minimize
price risk on these purchases, TEP, UNS Gas and UNS Electric enter into gas
price swap agreements under which they purchase gas at fixed prices and
simultaneously sell gas at spot market prices.
 
 On
the date the company enters into a derivative contract, we apply one of the
following accounting treatments:
  ·
                  Cash Flow Hedges are
      used by TEP and UNS Gas to hedge the changes in cash flows that are to be
      received or paid in connection with gas swap agreements and forward power
      sales.  These contracts hedge the cash flow risk associated with
      TEP’s summer load requirements and its forecasted excess generation and
      UNS Gas’ winter load requirement.  The effective portion of the
      changes in the market prices of cash flow hedges are recorded as
      unrealized gains and losses in Other Comprehensive Income (OCI) and
      the ineffective portion is recognized in
  earnings.
 
 ·
                  Mark-to-Market
      transactions include:
  o
                    TEP
      non-trading hedges, such as forward power purchase contracts indexed to
      gas that did not qualify for cash flow hedge accounting treatment or did
      not qualify for normal scope exception.  Unrealized gains and
      losses resulting from changes in the market prices of non-trading hedges
      are recorded on the same line in the income statement as the hedged
      transaction.
 
 o
                    TEP trading
      derivatives which are forward power purchase and sale contracts entered
      into to reduce our exposure to energy and commodity
      prices.  Unrealized gains and losses resulting from changes in
      the market prices of trading derivatives are recorded in the income
      statement in Electric Wholesale
Sales.
  o
                    UNS Electric
      derivatives such as forward power purchases and gas swaps.  In
      December 2006, UNS Electric received authorization from the ACC to defer
      the unrealized gains and losses on the balance sheet as a regulatory asset
      or a regulatory liability rather than as a component of OCI or in the
      income statement.
 20
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  These
mark-to-market contracts are subject to specified risk parameters established
and monitored by UniSource Energy’s Risk Management Committee.
 ·
                  Normal Purchase and Saletransactionsare derivative
      contracts entered into by TEP, UNS Gas and UNS Electric to support the
      current load forecast and entered into with a counterparty with load
      serving requirements or generating capacity.  These contracts
      are not required to be marked-to-market and are accounted for on an
      accrual basis.
 The net unrealized
gains and losses on derivative activities reported in Other Comprehensive Income
were as follows:
  UniSource
      Energy
                
                
                TEPThree
      Months
                
                
                Three
      MonthsEnded March
      31,
                
                
                Ended March
      31,Cash
      Flow Hedges - Activity
                
                2008
                
                
                2007
                
                
                2008
                
                
                2007-Millions of
      Dollars-Unrealized
      Gains (Losses) recorded to OCIForward Power Sales
                
                $
                (2
                )
                
                $
                (1
                )
                
                $
                (2
                )
                
                $
                (1
                )Gas Price Swaps
                
                
                13
                
                
                
                4
                
                
                
                11
                
                
                
                4Interest Rate Swap
                
                
                (2
                )
                
                
                -
                
                
                
                (2
                )
                
                
                -Total Pre-Tax Unrealized Gain
      (Loss)
                
                $
                9
                
                
                $
                3
                
                
                $
                7
                
                
                $
                3After-Tax
      Unrealized Gain (Loss) Recorded in OCI
                
                $
                6
                
                
                $
                2
                
                
                $
                4
                
                
                $
                2Unrealized
      (Gain) Loss Reclassified to Net Income
                
                $
                -
                
                
                $
                (2
                )
                
                $
                -
                
                
                $
                (2
                )
 
 TEP and UNS Gas
concluded, following an assessment at the inception of a hedge transaction and
on an ongoing basis that its derivatives, designated as cash flow hedges, have
been highly effective in offsetting changes in the cash flows of hedged items
and that those derivatives are expected to remain highly effective in future
periods.
 
 21
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  The net unrealized
gains and losses from Mark-to-Market derivative activities were as
follows:
  UniSource
      Energy
                
                
                TEPThree
      Months
                
                
                Three
      MonthsMark-to-Market
      Transactions – Unrealized Gain (Loss)
                
                Ended March
      31,
                
                
                Ended March
      31,Recorded
      in Earnings
                
                2008
                
                
                2007
                
                
                2008
                
                
                2007-Millions of
      Dollars-Recorded in
      Wholesale Sales:Forward Power Sales
                
                $
                (5
                )
                
                $
                (9
                )
                
                $
                (5
                )
                
                $
                (9
                )Forward Power
Purchases
                
                
                4
                
                
                
                8
                
                
                
                4
                
                
                
                8Forward Power
      Purchases Recorded in Purchased Energy
                
                
                (3
                )
                
                
                -
                
                
                
                (3
                )
                
                
                -Forward Gas
      Price Swaps Recorded in Fuel
                
                
                1
                
                
                
                -
                
                
                
                1
                
                
                
                -Total Pre-Tax Unrealized Gain
      (Loss)
                
                $
                (3
                )
                
                $
                (1
                )
                
                $
                (3
                )
                
                $
                (1
                )
   UniSource
      Energy
                
                
                TEPThree
      Months
                
                
                Three
      MonthsMark-to-Market
      Transactions – Increase (Decrease)
                
                Ended March
      31,
                
                
                Ended March
      31,Recorded
      in Regulatory Accounts on the Balance Sheet
                
                2008
                
                
                2007
                
                
                2008
                
                
                2007-Millions of
      Dollars-Recorded in
      Current Regulatory Assets – Derivatives:Gas Swaps
                
                $
                1
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -Recorded in
      Current Regulatory Liabilities – Derivatives:Gas Swaps
                
                
                2
                
                
                
                -
                
                
                
                -
                
                
                
                -Power Purchases
                
                
                10
                
                
                
                -
                
                
                
                -
                
                
                
                -Recorded in
      Other Regulatory Liabilities – Derivatives:Gas Swaps
                
                
                1
                
                
                
                -
                
                
                
                -
                
                
                
                -Power Purchases
                
                
                2
                
                
                
                1
                
                
                
                -
                
                
                
                -Total Increase
      (Decrease)
                
                $
                16
                
                
                $
                1
                
                
                $
                -
                
                
                $
                -
 
 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.  During the three months ended March 31, 2008, $18
million in sales were netted against $19 million in purchases.  During
the three months ended March 31, 2007, $44 million in sales were netted against
$43 million in purchases.
 
 The fair value of
UniSource Energy’s fuel and power related derivative assets and liabilities were
as follows:
 March
      31, 2008
                      
                      
                      December
      31, 2007Mark-to-Market
                        Contracts
                      
                      
                      Cash
      Flow
                        Hedges
                      
                      
                      Mark-to-Market
                        Contracts
                      
                      
                      Cash
      Flow
                        Hedges- Millions of
      Dollars -Derivative
      Assets – Current
                      
                      $
                      21
                      
                      
                      $
                      9
                      
                      
                      $
                      4
                      
                      
                      $
                      1Derivative
      Liabilities – Current
                      
                      
                      (8
                      )
                      
                      
                      (1
                      )
                      
                      
                      (2
                      )
                      
                      
                      (2
                      )Net Current
      Derivative Assets
                      
                      $
                      13
                      
                      
                      $
                      8
                      
                      
                      $
                      2
                      
                      
                      $
                      (1
                      )Derivative
      Assets – Noncurrent
                      
                      $
                      10
                      
                      
                      $
                      3
                      
                      
                      $
                      8
                      
                      
                      $
                      -Derivative
      Liabilities – Noncurrent
                      
                      
                      (1
                      )
                      
                      
                      (5
                      )
                      
                      
                      (2
                      )
                      
                      
                      (3
                      )Net
      Noncurrent Derivative Assets (Liabilities)
                      
                      $
                      9
                      
                      
                      $
                      (2
                      )
                      
                      $
                      6
                      
                      
                      $
                      (3
                      )
 22
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  The fair value of
TEP’s fuel and power related derivative assets and liabilities were as
follows:
  March
      31, 2008
                    
                    
                    December
      31, 2007Mark-to-Market
                      Contracts
                    
                    
                    Cash
      Flow
                      Hedges
                    
                    
                    Mark-to-Market
                      Contracts
                    
                    
                    Cash
      Flow
                      Hedges- Millions of
      Dollars -Derivative
      Assets – Current
                    
                    $
                    5
                    
                    
                    $
                    8
                    
                    
                    $
                    1
                    
                    
                    $
                    1Derivative
      Liabilities – Current
                    
                    
                    (7
                    )
                    
                    
                    (1
                    )
                    
                    
                    (1
                    )
                    
                    
                    (2
                    )Net Current
      Derivative Assets
                    
                    $
                    (2
                    )
                    
                    $
                    7
                    
                    
                    $
                    -
                    
                    
                    $
                    (1
                    )Derivative
      Assets – Noncurrent
                    
                    $
                    -
                    
                    
                    $
                    2
                    
                    
                    $
                    -
                    
                    
                    $
                    -Derivative
      Liabilities – Noncurrent
                    
                    
                    -
                    
                    
                    
                    (5
                    )
                    
                    
                    -
                    
                    
                    
                    (3
                    )Net
      Noncurrent Derivative Assets (Liabilities)
                    
                    $
                    -
                    
                    
                    $
                    (3
                    )
                    
                    $
                    -
                    
                    
                    $
                    (3
                    )
 At
March 31, 2008, TEP, UNS Electric and UNS Gas had contracts that will settle
through the second quarter of 2011, the fourth quarter of 2013, and the first
quarter of 2011, respectively.  Amounts presented as Cash Flow Hedges,
Derivative Assets – Current and Derivative Liabilities – Current, are expected
to be reclassified into earnings within the next twelve months.
 
 MEG
TRADING TRANSACTIONS
 
 MEG settled all of
its outstanding positions in December 2007 and has discontinued
operations.  MEG had no losses from trading activities for the three
months ended March 31, 2008.  MEG had a net loss from trading
activities of less than $0.5 million for the three months ended March 31,
2007.
 
 NOTE6.  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
                  
                  
                  TEPThree Months
      Ended
                  
                  
                  Three Months
      EndedMarch
      31,
                  
                  
                  March
      31,2008
                  
                  
                  2007
                  
                  
                  2008
                  
                  
                  2007-Thousands of
      Dollars -Federal
      Income Tax Expense (Benefit) at Statutory Rate
                  
                  $
                  (989
                  )
                  
                  $
                  3,085
                  
                  
                  $
                  (4,619
                  )
                  
                  $
                  661State Income
      Tax Expense (Benefit), Net of Federal Deduction
                  
                  
                  (130
                  )
                  
                  
                  407
                  
                  
                  
                  (607
                  )
                  
                  
                  87Depreciation
      Differences (Flow Through Basis)
                  
                  
                  585
                  
                  
                  
                  632
                  
                  
                  
                  585
                  
                  
                  
                  632Tax
      Credits
                  
                  
                  (137
                  )
                  
                  
                  (139
                  )
                  
                  
                  (137
                  )
                  
                  
                  (139
                  )Other
                  
                  
                  461
                  
                  
                  
                  (114
                  )
                  
                  
                  442
                  
                  
                  
                  (173
                  )Total
      Federal and State Income Tax Expense (Benefit)
                  
                  $
                  (210
                  )
                  
                  $
                  3,871
                  
                  
                  $
                  (4,336
                  )
                  
                  $
                  1,068
 
 Uncertain
Tax Positions
 
 FIN 48, Accounting
for Uncertainty in Income Taxes – An Interpretation of FAS 109 (FIN
48) issued July 2006, requires us to determine whether it is “more likely
than not” that we will sustain a tax position under examination.  Such
a position is measured to determine the amount of benefit to recognize in the
financial statements.  UniSource Energy adopted the provisions of FIN
48 on January 1, 2007.  The cumulative effects of applying this
interpretation were recorded as an increase of less than $1 million to retained
earnings and the recognition of a $13 million uncertain tax
liability.
  23
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  For the three
months ended March 31, 2008, UniSource Energy and TEP recorded a $0.4 million
decrease to unrecognized benefits taken in a prior period of which $0.2 million
was a result of a lapse of the applicable statute of limitations, no increases
or decreases in unrecognized tax benefits as a result of tax positions taken
during the current period, and no decrease in unrecognized tax benefits relating
to settlements with taxing authorities.
 
 For the three
months ended March 31, 2007, UniSource Energy and TEP recorded a $0.2
million decrease to unrecognized tax benefits taken in a prior period, no
increases or decreases in unrecognized tax benefits as a result of tax positions
taken during the current period, no decreases in unrecognized tax benefits
relating to settlements with taxing authorities, and no reductions in
unrecognized tax benefits as a result of a lapse of the applicable statue of
limitations.
 
 It
is reasonably possible that the total amounts of unrecognized tax benefits will
significantly change in the next 12 months.  The
potential estimated decrease in the next 12 months is $4 million due to the
closing of a statute.  This change will have no income statement
impact to UniSource Energy or TEP.  Tax years 2004 through 2007 are
open under Federal statutes and tax years 2002 through 2007 are open under
Arizona and New Mexico statutes.
 
 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.  We also used the new
accounting method on the 2003 and 2004 returns for TEP, UNS Gas and UNS
Electric.
 
 In
2005, the Internal Revenue Service issued a ruling limiting the ability of
electric and gas utilities to use the new accounting method.  As a
result, TEP, UNS Gas and UNS Electric amended their 2002, 2003 and 2004 federal
and state tax returns to remove the benefit previously claimed using the
accounting method and remitted tax and interest of $31 million, $1 million and
$0.3 million, respectively, to the IRS and state tax
authorities.  Based on settlement guidelines relating to the
accounting method that were issued by the IRS in March 2007, TEP, UNS Gas and
UNS Electric have settled this issue with the IRS.  In December 2007,
TEP recorded the effect of the settlement by recognizing $2 million of interest
income. For the quarter ended March 31, 2008, TEP recorded additional interest
income of $0.2 million. TEP received an $8 million refund of taxes and interest
in April 2008.  TEP anticipates receiving an additional $5 million of
taxes and interest during 2008.  The refunds have no income statement
impact to UniSource Energy or TEP.
 NOTE7.  COMMITMENTS AND CONTINGENCIES
 
 TEP
COMMITMENTS
 
 In
March and April 2008, TEP entered into additional power supply agreements for
the periods June through September 2008 and 2009.  These contracts are
indexed to natural gas prices.  TEP estimates its minimum payments
under these contracts to be $58 million in 2008 and $9 million in
2009.
 
 In
March 2008, TEP entered into a five year gas transportation agreement with El
Paso Natural Gas.  TEP estimates its minimum payments under this
contract to be $3 million in each of 2008 and 2009, $4 million in each of 2010
through 2012, and less than $1 million in 2013.
 
 In
2008, TEP entered into additional forward gas purchase agreements through April
2011.  TEP estimates its minimum payments for these forward purchases
to be $13 million in 2008 and $1 million in each of 2009 and 2010.
 
 UNS
ELECTRIC COMMITMENTS
 
 In
2008, UNS Electric entered into forward gas purchase agreements through February
2011.  UNS Electric estimates its minimum payments for these forward
purchases to be less than $1 million in each of 2008 through 2011.
 
 24
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  UNS Electric
entered into a Power Purchase and Sales Agreement (PPA) with UED through May
2013 which is subject to FERC approval.  UNS Electric estimates, to
the extent that the agreement becomes effective, its minimum payments under this
agreement to be $6 million in 2008, $10 million annually from 2009 to 2012 and
$4 million in 2013.  See Note 2.
 
 In
2006 and 2007, UNS Electric entered into various power supply agreements for
periods of one to five years beginning in June 2008.  Certain of these
contracts are at a fixed price per MW and others are indexed to natural gas
prices.  UNS Electric estimates its future minimum payments under
these contracts to be $64 million in 2008, $72 million in 2009, $39 million in
2010, $15 million in 2011, $9 million in 2012, and $9 million thereafter based
on natural gas prices at March 31, 2008.
 
 UNS
GAS COMMITMENTS
 
 In
March and April 2008, UNS Gas entered into forward gas purchase agreements
through April 2011.  UNS Gas estimates it minimum payments for these
forward purchases to be $2 million in 2008, $4 million in 2009, and $1 million
in each of 2010 and 2011.
 
 TEP
CONTINGENCIES
  Regional
Haze
 
 The EPA's regional
haze rules require emission controls known as Best Available Retrofit
Technology (BART) for industrial facilities emitting air pollutants that reduce
visibility.  The operators of the Four Corners, Navajo, and San Juan
generating stations submitted BART analyses in 2007 and early
2008.  PNM, operator of San Juan, believes the controls being
installed at San Juan as a result of the 2005 settlement agreement between PNM,
environmental activist groups, and the New Mexico Environment Department
constitute BART and did not recommend installation of any additional pollution
control equipment.  The operators of the Four
Corners and Navajo generating stations recommended installing certain
additional pollution control equipment in their respective BART
analyses.  The level and cost of pollution control required, if any,
will not be known until the plans are approved by the regulatory
agencies.  If required, controls would need to be in place by 2013 or
later.
  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 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 impact of any future claims by these gas producers
on the cost of coal at San Juan.
 
 Litigation
and Claims Related to Navajo Generating Station
 
 In
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. 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.  TEP has not recorded a liability for these
amounts.
 
 Postretirement
and Pension Benefit Costs at Navajo Generating Station
 
 Peabody contends
that the Navajo Generating Station participants are responsible under the coal
supply agreements for postretirement benefit costs payable to the coal
supplier’s employees.  In 1996, SRP filed a lawsuit in Maricopa County
Superior Court on behalf of the participants at Navajo Generating Station,
including TEP, seeking declaratory judgment that the participants are not
responsible for these costs.  The Navajo Generating Station
participants and Peabody continue to discuss a potential
settlement.  We expect resolution of this matter in 2008.
 
 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 corresponding coal supply
agreement.  At March 31, 2008, TEP has recorded a liability of $5
million based on our $13 million obligation at the expiration dates of the coal
supply agreements in 2011 through 2017.  At December 31, 2007, TEP had
recorded a liability of $4 million.
  25
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
 Amounts recorded
for final reclamation are subject to various assumptions, such as estimating the
costs of reclamation, when final reclamation will occur, and the credit-adjusted
risk-free interest rate to be used to discount future liabilities.  As
these assumptions change, TEP will prospectively adjust the expense amounts for
final reclamation over the remaining coal supply agreement term.  TEP
does not believe that recognition of its final reclamation obligations will be
material to TEP in any single year because recognition occurs over the remaining
terms of its coal supply agreements.
 
 TEP
Wholesale Accounts Receivable and Allowances
 
 TEP’s Accounts
Receivable from Electric Wholesale Sales includes $16 million of receivables at
March 31, 2008 and December 31, 2007 related to sales to the California Power
Exchange (CPX) and the California Independent System Operator (CISO) in 2001 and
2000.  TEP’s Allowance for Doubtful Accounts on the balance sheet
includes $13 million at March 31, 2008 and December 31, 2007 related to these
sales.  There are several 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.
 
 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 senior unsecured notes issued in 2003 by UNS Gas ($100
      million) and UNS Electric ($60
million),
 ·
                  UES’
      guarantee of a $60 million unsecured revolving credit agreement for UNS
      Gas and UNS Electric, and
 ·
                  UniSource
      Energy’s guarantee of approximately $2 million in building lease payments
      for UNS Gas.
 To the extent
liabilities exist under these contracts, the liabilities are included in our
consolidated balance sheets.
 
 In
addition, we have indemnified the purchasers of interests in certain investments
from additional taxes due for years before the sale of such
investments.  The terms of the indemnifications do not include a limit
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 or UES would be required to perform
or otherwise incur any significant losses associated with any of these
guarantees or indemnities is remote.
 
 NOTE8.  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.
  26
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  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 FAS 106, Employers’
Accounting for Postretirement Benefits Other Than Pensions, over actual
benefit payments.
 
 COMPONENTS
OF NET PERIODIC BENEFIT COST
 
 The components of
UniSource Energy’s net periodic benefit costs are as follows:
 
 Pension
      Benefits
                
                
                Other
      Postretirement
                  BenefitsThree Months
      Ended
                
                
                Three Months
      EndedMarch
      31,
                
                
                March
      31,2008
                
                
                2007
                
                
                2008
                
                
                2007-Millions of
      Dollars -Components
      of Net Periodic Benefit CostService
      Cost
                
                $
                2
                
                
                $
                2
                
                
                $
                -
                
                
                $
                -Interest
      Cost
                
                
                4
                
                
                
                3
                
                
                
                1
                
                
                
                1Expected
      Return on Plan Assets
                
                
                (4
                )
                
                
                (4
                )
                
                
                -
                
                
                
                -Recognized
      Actuarial Loss
                
                
                -
                
                
                
                1
                
                
                
                -
                
                
                
                -Net Periodic Benefit
      Cost
                
                $
                2
                
                
                $
                2
                
                
                $
                1
                
                
                $
                1
 
 The table above
includes pension benefit costs of less than $0.4 million and other
postretirement benefit costs of less than $0.1 million for UNS Gas and UNS
Electric.
 
 On
January 1, 2008, UniSource Energy and TEP adopted the measurement date
provisions of FAS 158, “Employers’ Accounting for Defined
Benefit Pension and Other Postretirement Plans, an amendment of FAS Statements
No.87, 88, 106, and 132(R).”  The measurement date provisions
require plan assets and obligations to be measured as of the employer’s balance
sheet date.  UniSource Energy and TEP previously measured its other
postretirement benefit obligations as of December 1 each year.  As a
result of the adoption of the measurement date provisions, UniSource Energy and
TEP recorded an increase of $0.6 million and $0.5 million, respectively to their
postretirement benefit liability, and a corresponding increase to accumulated
deficit, representing the net periodic benefit cost for the period between the
measurement date utilized in 2007 and the beginning of 2008.  The
adoption of the measurement provisions of FAS 158 had no effect on UniSource
Energy's or TEP’s income statements.
 
 NOTE9.  SHARE-BASED COMPENSATION PLANS
 
 Under the 2006
Omnibus Stock and Incentive Plan, the Compensation Committee of the UniSource
Energy Board of Directors may issue various types of share-based compensation,
including stock options, restricted shares/units, and performance
shares.  The total number of shares which may be awarded under the
Plan cannot exceed 2.25 million shares.  As of March 31, 2008, the
total number of shares awarded under the 2006 Omnibus Stock and Incentive Plan
was 0.8 million shares.
 
 STOCK
OPTIONS
 
 On
February 27, 2008, the Compensation Committee of the UniSource Energy Board of
Directors granted 303,550 stock options to officers with an exercise price of
$26.18.  In March 2007, the Compensation Committee granted 184,260
stock options to officers with an exercise price of $37.88.
 
 Stock options are
granted with an exercise price equal to the fair market value of the stock on
the date of grant, 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 is recorded on a
straight-line basis over the service period for the total award based on the
grant date fair value of the options less estimated
forfeitures.  For
  27
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  awards granted to
retirement eligible officers, compensation expense is recorded
immediately.  Certain stock option awards 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.
 
 The fair value of
each option award is estimated on the date of grant using the
Black-Scholes-Merton option pricing model with the assumptions noted in the
following table.  The expected term of the stock options granted in
February 2008 was estimated using historical exercise data.  The
expected term of all other options granted in prior years was estimated using a
“simplified” method which considers the 3 year vesting period and the
contractual term.  The risk-free rate is based on the rate available
on a U.S. Treasury Strip with a maturity equal to the expected term of the
option at the time of the grant.  Expected volatility was based on
historical volatility for UniSource Energy’s stock for the past 6 years, the
expected term.  The expected dividend yield on a share of stock was
calculated using the historical dividend yield with the implicit assumption that
current dividend yields will continue in the future.
 
 2008
      Grant
                2007
      GrantExpected term
      (years)
                6
                6Risk-free
      rate
                3.1%
                4.4%Expected
      volatility
                18.8%
                20.2%Expected
      dividend yield
                2.8%
                2.4%Weighted-average
      grant-date fair value of options granted
                $4.23
                $8.13
 
 A
summary of stock option activity follows:
  Three
      Months Ended March 31, 2008Total
      Stock Options Outstanding
                
                Non-Vested
      Stock OptionsWeighted
                
                
                WeightedAverage
                
                
                AverageExercise
                
                
                Grant
      Date(Shares in
      Thousands)
                
                Shares
                Price
                
                Shares
                ValueOptions
      Outstanding, December 31, 2007
                
                1,451
                $21.21
                
                312
                $7.83Granted
                
                304
                $26.18
                
                304
                $4.23Exercised or Vested
                
                (44)
                $17.14
                
                (61)
                $8.13Options
      Outstanding, March 31, 2008
                
                1,711
                $22.20
                
                555
                $5.82Options
      Exercisable, March 31, 2008
                
                1,156
                $18.52Aggregate
      Intrinsic Value of Options Exercised ($000’s)
                
                $353
  At
      March 31, 2008
                  ($000s)Aggregate
      Intrinsic Value for Options Outstanding
                $6,063Aggregate
      Intrinsic Value for Options  Exercisable
                $6,063Weighted
      Average Remaining Contractual Life
                5.3
      yearsWeighted
      Average Remaining Contractual Life of Exercisable Shares
                3.5
      years
  28
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  Exercise prices for
stock options outstanding and exercisable as of March 31, 2008 are summarized as
follows:
 
 Options
      Outstanding
                Options
      ExercisableRange
      of Exercise Prices
                Number
      of
                  Shares
                  (000s)
                Weighted-
                  Average
                  Remaining
                  Contractual
                  Life
                Weighted-
                  Average
                  Exercise
                  Price
                Number
                  of
      Shares
                  (000s)
                Weighted-
                  Average
                  Exercise
                  Price$11.00 -
      $15.56
                472
                1.8
      years
                $14.27
                472
                $14.27$17.44 -
      $18.84
                541
                3.7
      years
                $18.02
                541
                $18.02$26.18 -
      $37.88
                698
                8.8
      years
                $30.80
                144
                $34.38
 
 RESTRICTED
STOCK UNITS AND PERFORMANCE SHARES
 
 Restricted
Stock Units
 
 In
February 2008, the Compensation Committee of the UniSource Energy Board of
Directors granted 3,130 stock units at a weighted average fair value of $28.75
per share to non-employee directors.  The restricted stock units vest
in one year or immediately upon death, disability, or retirement.  In
the January following the year the person is no longer a Director, Common Stock
shares will be issued for the vested stock units.  There were no
restricted stock unit awards granted during the three months ended March 31,
2007.
 
 Performance
Share Awards
 
 On
February 27, 2008, the Compensation Committee of the UniSource Energy Board of
Directors granted 49,120 performance share awards (targeted shares) to Officers
at a grant date fair value of $17.10 per share.  The performance share
awards will be paid out in shares of UniSource Energy common stock based on
UniSource Energy’s performance over the performance period of January 1, 2008
through December 31, 2010.  The performance criteria specified in the
awards is determined based on targeted UniSource Energy Total Shareholder Return
(TSR) during the performance period.  The performance shares vest
ratably over the performance period and any unearned awards are
forfeited.  Compensation expense equal to the fair value on the grant
date is recognized over the vesting period if it is probable that the
performance criteria will be met.
 
 On
March 20, 2007, the Compensation Committee of the UniSource Energy Board of
Directors granted 37,270 performance share awards (targeted shares) to certain
officers at a grant date fair value of $35.56 per share (market price of $37.88
less the present value of expected dividends of $2.32).  The
performance share awards will be paid out in shares of UniSource Energy Common
Stock based on UniSource Energy’s earnings per share and cash flow performance
over the performance period of January 1, 2007 through December 31,
2009.
 
 SHARE-BASED
COMPENSATION EXPENSE
 
 UniSource Energy
and TEP recorded compensation expense of $1 million for the three months ended
March 31, 2008 and 2007.  We did not capitalize any share-based
compensation costs.
 
 At
March 31, 2008, the total unrecognized compensation cost related to non-vested
share-based compensation was $1 million which will be recorded as compensation
expense over the remaining vesting periods through March 2010.  The
total number of shares awarded but not yet issued, including target performance
based shares, under the share-based compensation plans at March 31, 2008 was 1.9
million.
 
 NOTE10.  FAIR VALUE MEASUREMENTS
 
 Effective January
1, 2008, we adopted FAS 159, The Fair Value Option for Financial
Assets and Financial Liabilities, which provides companies with the
option of measuring certain financial assets and liabilities and other items at
fair value with changes in fair value recognized in earnings as those changes
occur.  We have not elected fair value accounting for any of our
eligible financial instruments.
  29
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  Effective January
1, 2008, we adopted FAS 157, Fair Value Measurements,
which defines fair value, establishes a framework for measuring fair value, and
expands disclosures about fair value measurements.  As defined in FAS
157, fair value is the price that would be received to sell an asset or paid to
transfer a liability between market participants at the measurement date (exit
price).  FAS 157 clarifies that the exchange price is the price in the
principal market in which the reporting entity would transact for the asset or
liability.  With limited exceptions, the provisions of FAS 157 are
applied prospectively.  There was no transition adjustment as a result
of adopting FAS 157.
 
 As
permitted by FSP FAS 157-2 we have elected to defer the adoption of the
nonrecurring fair value measurement disclosures of nonfinancial assets and
liabilities, such as asset retirement obligations, until January 1,
2009.
 
 In
accordance with FAS 157, we have categorized our financial instruments, based on
the priority of the inputs to the valuation technique, into a three-level fair
value hierarchy. The fair value hierarchy gives the highest priority to quoted
prices in active markets for identical assets or liabilities (Level 1) and the
lowest priority to unobservable inputs (Level 3).  The three levels of
the fair value hierarchy defined by FAS 157 are as follows:
 
 Level
      1.
                Financial
      assets and liabilities whose values are based on unadjusted quoted prices
      for identical assets or liabilities in an active market (examples include
      active exchange-traded equity securities, listed
    derivatives).
 
 Level
      2.
                Financial
      assets and liabilities whose values are based on quoted prices for similar
      assets or liabilities in active markets, quoted prices for identical or
      similar assets or liabilities in non-active markets (examples include
      corporate bonds, which trade infrequently), pricing models whose inputs
      are observable for substantially the full term of the asset or liabilities
      (examples include most non-exchange-traded derivatives, including interest
      rate swaps), and pricing models whose inputs are derived principally from
      or corroborated by observable market data through correlation or other
      means for substantially the full term of the asset or
      liability.
 
 Level
      3.
                Financial
      assets and liabilities whose values are based on prices or valuation
      techniques that require inputs that are both unobservable and significant
      to the overall fair value measurement. These inputs reflect management’s
      own assumptions about the assumptions a market participant would use in
      pricing the asset or liability (examples include long-dated or complex
      derivatives including certain long dated options on gas and
      power).
 
 The following
tables set forth, by level within the fair value hierarchy, UniSource Energy and
TEP’s financial assets and liabilities that were accounted for at fair value on
a recurring basis as of March 31, 2008.  As required by FAS 157,
financial assets and liabilities are classified in their entirety based on the
lowest level of input that is significant to the fair value
measurement.
 
 UniSource
      EnergyQuoted
      Prices
                  in
      Active
                  Markets
      for
                  Identical
      Assets
                  (Level
      1)
                
                
                Significant
                  Other
                  Observable
                  Inputs
                  (Level
      2)
                
                
                Significant
                  Unobservable
                  Inputs
                  (Level
      3)
                
                
                TotalMarch
      31, 2008- Millions of
      Dollars -Energy
      Contracts (1)
                
                $
                -
                
                
                $
                16
                
                
                $
                17
                
                
                $
                33Cash
      Collateral (2)
                
                
                -
                
                
                
                1
                
                
                
                -
                
                
                
                1Investments
      (3)
                
                
                -
                
                
                
                13
                
                
                
                -
                
                
                
                13Deferred
      Compensation
                
                
                -
                
                
                
                (5
                )
                
                
                -
                
                
                
                (5
                )Interest Rate
      Swap
                
                
                -
                
                
                
                (5
                )
                
                
                -
                
                
                
                (5
                )Total
                
                $
                -
                
                
                $
                20
                
                
                $
                17
                
                
                $
                37
 30
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  TEPQuoted
      Prices
                  in
      Active
                  Markets
      for
                  Identical
      Assets
                  (Level
      1)
                
                
                Significant
                  Other
                  Observable
                  Inputs
                  (Level
      2)
                
                
                Significant
                  Unobservable
                  Inputs
                  (Level
      3)
                
                
                TotalMarch
      31, 2008- Millions of
      Dollars -Energy
      Contracts (1)
                
                $
                -
                
                
                $
                11
                
                
                $
                (4
                )
                
                $
                7Cash
      Collateral (2)
                
                
                -
                
                
                
                1
                
                
                
                -
                
                
                
                1Investments
      (3)
                
                
                -
                
                
                
                13
                
                
                
                -
                
                
                
                13Deferred
      Compensation
                
                
                -
                
                
                
                (5
                )
                
                
                -
                
                
                
                (5
                )Interest Rate
      Swap
                
                
                -
                
                
                
                (5
                )
                
                
                -
                
                
                
                (5
                )Total
                
                $
                -
                
                
                $
                15
                
                
                $
                (4
                )
                
                $
                11
 
 (1) Energy
Contracts include forward power purchase and sales contracts, gas swap
agreements and forward power purchase contracts indexed to gas, entered into to
take advantage of favorable market conditions and reduce exposure to energy
price risk.
 (2) Cash Collateral
relates to the payment of cash as collateral against the fair value of TEP’s
trading derivatives.
 (3) Investments are
amounts held in trust to fund deferred compensation and Supplemental Executive
Retirement Plan benefits.
 
 TEP, UNS Gas and
UNS Electric primarily apply the market approach for recurring fair value
measurements and endeavor to utilize the best available
information.  Where observable inputs are available for substantially
the full terms of the asset or liability, such as gas swap derivatives valued
using quoted gas prices, the instrument is categorized in Level
2.  Derivatives valued using an aggregate pricing service or published
prices that represent a consensus reporting of multiple brokers are categorized
in Level 3.  In addition, complex or structured transactions can
introduce the need for internally-developed model inputs that might not be
observable in or corroborated by the market. When such inputs have a significant
impact on the measurement of fair value, the instrument is categorized in Level
3.
 
 TEP, UNS Gas and
UNS Electric’s assessment of the significance of a particular input to the fair
value measurements requires judgment, and may affect the valuation of fair value
assets and liabilities and their placement within the fair value hierarchy
levels.
 
 The following
tables set forth a reconciliation of changes in the fair value of net trading
derivatives classified as Level 3 in the fair value hierarchy:
 
 UniSource
      Energy- Millions of
      Dollars -Income
      Statement
                
                
                Balance
      Sheet
                
                
                TotalWholesale
      Sales
                
                
                Fuel
                
                
                Purchased
      Energy
                
                
                OCI
                
                
                Net
                  Regulatory
                  LiabilitiesBalance
      as of January 1, 2008
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                10
                
                
                $
                10Gains and
      (Losses) (realized/unrealized)
                
                
                -
                
                
                
                -
                
                
                
                (3
                )
                
                
                (1
                )
                
                
                11
                
                
                
                7Purchases,
      Issuances, and Settlements
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Balance
      as of March 31, 2008
                
                $
                -
                
                
                $
                -
                
                
                $
                (3
                )
                
                $
                (1
                )
                
                $
                21
                
                
                $
                17
 
 31
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  TEP- Millions of
      Dollars -Income
      Statement
                
                
                Balance
      Sheet
                
                
                TotalWholesale
      Sales
                
                
                Fuel
                
                
                Purchased
      Energy
                
                
                OCI
                
                
                Net
                  Regulatory
                  LiabilitiesBalance
      as of January 1, 2008
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -Gains and
      (Losses) (realized/unrealized)
                
                
                -
                
                
                
                -
                
                
                
                (3
                )
                
                
                (1
                )
                
                
                -
                
                
                
                (4
                )Purchases,
      Issuances, and Settlements
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Balance
      as of March 31, 2008
                
                $
                -
                
                
                $
                -
                
                
                $
                (3
                )
                
                $
                (1
                )
                
                $
                -
                
                
                $
                (4
                )
 
 All of the gains
and losses disclosed in the Level 3 tables above are attributable to the change
in fair value of Level 3 derivatives assets and liabilities held at the
reporting date.
 
 There were no
transfers in or out of Level 3 derivatives.
 
 NOTE11.  UNISOURCE ENERGY EARNINGS (LOSS)  PER SHARE
(EPS)
 
 Basic EPS is
computed by dividing Net Income (Loss) 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 (Loss) adjusted for the
interest on convertible notes (net of tax) that would not be paid if the notes
were converted to common shares.
 
 The following table
shows the effects of potential dilutive common stock on the weighted average
number of shares:
  Three Months
      EndedMarch
      31,2008
                  
                  
                  2007- In
      Thousands -Numerator:Net Income (Loss)
                  
                  $
                  (2,615
                  )
                  
                  $
                  4,943Income from Assumed Conversion of
      Convertible Senior Notes
                  
                  
                  -
                  
                  
                  
                  -Adjusted
      Numerator
                  
                  $
                  (2,615
                  )
                  
                  $
                  4,943Denominator:Weighted-average
      Shares of Common Stock Outstanding:Common Shares
      Issued
                  
                  
                  35,354
                  
                  
                  
                  35,213Fully Vested
      Deferred Stock Units
                  
                  
                  205
                  
                  
                  
                  209Total
      Weighted-average Shares of Common Stock Outstanding-Basic
                  
                  
                  35,559
                  
                  
                  
                  35,422Effect of
      Dilutive Securities:Convertible
      Senior Notes
                  
                  
                  -
                  
                  
                  
                  -Options and Stock Issuable Under
      Employee Benefit Plansand the
      Directors’ Plans
                  
                  
                  -
                  
                  
                  
                  607Total Shares
      - Diluted
                  
                  
                  35,559
                  
                  
                  
                  36,029
 Stock options to
purchase 395,000 and 25,000 shares of Common Stock were outstanding during the
three months ended March 31, 2008 and 2007, respectively, but were not included
in the computation of diluted EPS because the stock option’s exercise price was
greater than the average market price of the Common
Stock.  Additionally, for the three months ended March 31, 2008, 4
million potentially dilutive shares from the conversion of convertible senior
notes, 0.5 million of options and stock issuable under employee benefit plans
and the director plans and after-tax interest expense of $1 million were not
included in the computation of diluted EPS because to
  32
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  do so would be
anti-dilutive.  For the three months ended March 31, 2007, 4 million
potentially dilutive shares from the conversion of convertible senior notes and
after-tax interest expense of $1 million were excluded from the computation of
diluted EPS because to do so would be anti-dilutive.
 
 NOTE12.  NEW ACCOUNTING PRONOUNCEMENTS
 
 The FASB recently
issued the following Statements of Financial Accounting Standards
(FAS):
 ·
                  FAS 161,
      Disclosures About
      Derivative Instruments and Hedging Activitiesan amendment to FAS
      133, Accounting for
      Derivative Instruments and Hedging Activities,issued March 2008,
      requires enhanced disclosures about an entity’s derivative and hedging
      activity.The
      standard requires that the objectives for using derivative instruments be
      disclosed in terms of underlying risk so that the reader understands the
      purpose of derivative use in terms of the risks that the entity is
      intending to manage.  The standard also requires disclosure of
      the location in the financial statements of derivative balances as well as
      the location of gains and losses incurred during the reporting
      period.  The standard will be applicable for fiscal years or
      interim periods beginning on or after November 15, 2008, with early
      adoption encouraged.  The company is assessing the impact of
      this standard.
 
 ·
                  FAS 160,
      Accounting and Reporting
      of Noncontrolling Interests in Consolidated Financial Statements,issued December 2007, will change the accounting and reporting for
      minority interests, requiring such amounts to be classified as a component
      of equity, and will also change the accounting for transactions with
      minority-interest holders. The standard will be applicable for fiscal
      years beginning on or after December 15, 2008 on a prospective
      basis.  Early adoption is prohibited and business combinations
      with acquisition dates prior to the effective date will not be adjusted
      upon application.  We do not expect this pronouncement to have a
      material impact on our financial
statements.
 
 ·
                  FAS 141(R)
      Business
      Combinations - a replacement of FAS No. 141, issued December 2007,
      requires companies to record acquisitions at fair value.  FAS
      141(R) changes the definition of a business and a business combination and
      is generally expected to increase the number of transactions that will
      need to be accounted for at fair value.  The standard will be
      applicable for fiscal years beginning on or after December 15, 2008 and
      generally on a prospective basis.  Early adoption is prohibited
      and business combinations with acquisition dates prior to the effective
      date will not be adjusted upon application.  We do not expect
      this pronouncement to have a material impact on our financial
      statements.
 
 33
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (continued) - Unaudited
  NOTE13.  SUPPLEMENTAL CASH FLOW INFORMATION
 
 A reconciliation of Net Income (Loss) to Net
Cash Flows - Operating Activities follows:
 
 UniSource
      EnergyThree Months
      EndedMarch
      31,2008
                
                
                2007-Thousands of
      Dollars-Net
      Income (Loss)
                
                $
                (2,615
                )
                
                $
                4,943Adjustments
      to Reconcile Net Income (Loss) To Net Cash FlowsDepreciation and Amortization
      Expense
                
                
                36,154
                
                
                
                34,466Depreciation and Amortization Recorded
      to Fuel and Other O&M Expense
                
                
                1,660
                
                
                
                1,874Amortization of Transition Recovery
      Asset
                
                
                17,250
                
                
                
                14,986Mark-to-Market
    Transactions
                
                
                3,427
                
                
                
                945Net Unrealized Loss on MEG Trading
      Activities
                
                
                -
                
                
                
                2,135Amortization
      of Deferred Debt-Related Costs included in Interest
Expense
                
                
                949
                
                
                
                980Provision for
      Bad Debts
                
                
                809
                
                
                
                827Deferred Income Taxes
                
                
                25,292
                
                
                
                26,328Pension and
      Postretirement Expense
                
                
                2,998
                
                
                
                3,611Pension and
      Postretirement Funding
                
                
                (3,273
                )
                
                
                (767
                )Stock
      Based Compensation Expense
                
                
                1,143
                
                
                
                967Excess Tax Benefit from Stock Option
      Exercises
                
                
                (135
                )
                
                
                (325
                )Changes in Assets and Liabilities which
      Provided (Used)Cash Exclusive of Changes Shown SeparatelyAccounts Receivable
                
                
                20,844
                
                
                
                28,575Materials and Fuel
      Inventory
                
                
                (514
                )
                
                
                (3,060
                )Over/Under Recovered Purchased Gas
      Cost
                
                
                (6,931
                )
                
                
                (108
                )Accounts Payable
                
                
                (7,027
                )
                
                
                (5,578
                )Interest Accrued
                
                
                (20,858
                )
                
                
                (25,562
                )Income
      Tax Receivable/Payable
                
                
                (26,012
                )
                
                
                (29,285
                )Taxes Other Than Income
      Taxes
                
                
                10,699
                
                
                
                11,520Other
                
                
                736
                
                
                
                (2,728
                )Net
      Cash Flows – Operating Activities
                
                $
                54,596
                
                
                $
                64,744
  34
 Table of Contents
  NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (concluded) - Unaudited
  TEPThree Months
      EndedMarch
      31,2008
                
                
                2007-Thousands of
      Dollars-Net
      Income (Loss)
                
                $
                (8,862
                )
                
                $
                821Adjustments
      to Reconcile Net Income (Loss) To Net Cash FlowsDepreciation and Amortization
      Expense
                
                
                31,290
                
                
                
                29,062Depreciation and Amortization Recorded
      to Fuel and Other O&M Expense
                
                
                1,287
                
                
                
                1,519Amortization of Transition Recovery
      Asset
                
                
                17,250
                
                
                
                14,986Mark-to-Market
    Transactions
                
                
                3,427
                
                
                
                945Amortization of Deferred Debt-Related
      Costs included in Interest Expense
                
                
                670
                
                
                
                662Provision for Bad Debts
                
                
                391
                
                
                
                444Deferred Income Taxes
                
                
                24,371
                
                
                
                24,838Pension and Postretirement Expense
                
                
                2,601
                
                
                
                3,171Pension
      and Postretirement Funding
                
                
                (2,844
                )
                
                
                (727
                )Stock Based Compensation Expense
                
                
                882
                
                
                
                753Changes in Assets and Liabilities which
      Provided (Used)Cash Exclusive of Changes Shown SeparatelyAccounts Receivable
                
                
                14,648
                
                
                
                18,573Materials and Fuel
      Inventory
                
                
                (688
                )
                
                
                (3,805
                )Accounts Payable
                
                
                (141
                )
                
                
                (728
                )Interest Accrued
                
                
                (16,252
                )
                
                
                (20,994
                )Income Tax
      Receivable/Payable
                
                
                (21,888
                )
                
                
                (32,005
                )Taxes Other Than Income
      Taxes
                
                
                8,681
                
                
                
                9,598Other
                
                
                698
                
                
                
                2,609Net
      Cash Flows – Operating Activities
                
                $
                55,521
                
                
                $
                49,722
  NOTE14.  REVIEW BY INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM
  The UniSource
Energy and TEP condensed consolidated financial statements as of March 31, 2008,
and for the three months ended March 31, 2008, and 2007, have been reviewed by
PricewaterhouseCoopers LLP, an independent registered public accounting
firm.  Their reports (dated May 1, 2008) are included on pages 1 and
2.  The reports of PricewaterhouseCoopers LLP state that they did not
audit and they do not express an opinion on that unaudited financial
information.  Accordingly, the degree of reliance on their reports 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 reports on the unaudited financial information because neither of
those reports is a “report” or a “part” of the registration statement prepared
or certified by PricewaterhouseCoopers LLP within the meaning of Sections 7 and
11 of the Act.
  35
 Table of Contents
  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 ended March 31, 2008 compared with the
      same period in 2007,
 ·
              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 2007 Annual Report on Form 10-K and with the Comparative Condensed
Consolidated Financial Statements, beginning on page 3, which present the
results of operations for the three months ended March 31, 2008 and
2007.  Management’s Discussion and Analysis explains the differences
between periods for specific line items of the Comparative 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).  We
conduct our business in three primary business segments – TEP, UNS Gas and UNS
Electric.
 
 TEP, an electric
utility, has provided electric service to the community of Tucson, Arizona, for
over 100 years.  UES was established in 2003, when it acquired the
Arizona gas and electric properties from Citizens.  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.  These companies are regulated by the Arizona
Corporation Commission (ACC).
 
 Millennium has
existing investments in unregulated businesses that represent 3% of UniSource
Energy’s total assets as of March 31, 2008; no new investments are planned at
Millennium.  UED facilitated the expansion of the Springerville
Generating Station and is currently developing the Black Mountain Generating
Station (BMGS), a gas turbine project in Northern Arizona that, subject to
approval, is expected to provide energy to UNS Electric.
 
 OUTLOOKAND 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:
 
 ·
              Obtain ACC
      approval of a rate increase for TEP, effective on or before January 1,
      2009, that resolves the uncertainty surrounding TEP’s rates for generation
      service after 2008, while providing adequate revenues to cover the rising
      cost of serving TEP’s customers and preserving TEP’s benefits under the
      1999 Settlement Agreement;
 
 ·
              Obtain ACC
      approval of rate increases for UNS Gas and UNS Electric to provide
      adequate revenues to cover the rising cost of providing service to their
      customers;
 
 ·
              Efficiently
      manage our generation, transmission and distribution resources and seek
      ways to control our operating expenses while maintaining and enhancing
      reliability, safety and
profitability;
  36
 Table of Contents
  ·
              Diversify
      TEP’s portfolio of generating and purchased power resources, along with
      programs to expand renewable energy sources and demand side management, to
      meet growing retail energy demand and respond to wholesale market
      opportunities;
 
 ·
              Expand UNS
      Electric’s portfolio of generating and purchased power resources to
      substitute for the May 31, 2008 expiration of the full requirements
      contract with Pinnacle West Marketing and Trading (PWMT) and to meet
      growing retail energy demand;
 
 ·
              Enhance the
      value of existing generation assets by working with SRP to support the
      construction of Springerville Unit
4;
 
 ·
              Enhance the
      value of TEP’s transmission system while continuing to provide reliable
      access to generation for TEP and UNS Electric’s retail customers and
      market access for all generating
assets;
 
 ·
              Continue to
      develop synergies between UNS Gas, UNS Electric and
  TEP;
 
 ·
              Improve
      UniSource Energy’s and TEP’s ratio of common equity to total
      capitalization; and
 
 ·
              Promote
      economic development in our service
territories.
 
 To accomplish our
goals, during 2008 we expect to spend the following amounts on capital
expenditures:
 
 Actual
      Year-to-Date
                March 31,
      2008
              Estimate
                Full Year
      2008-Millions of
      Dollars-TEP
              $74
              $317UNS
      Gas
              4
              26UNS
      Electric
              8
              36Other (1)
              4
              20UniSource
      Energy Consolidated
              $90
              $399
 
 (1)Represents capital expenditures by UED related to the construction of the
90 MW BMGS  in
Kingman, Arizona, in
 UNS
Electric’s service area.  The project is expected to be completed in
2008.
 
 
 RESULTSOF OPERATIONS
 
 Executive
Overview
 
 UniSource Energy
reported a net loss of $3 million in the first quarter of 2008 compared with net
income $5 million in the first quarter of 2007.
  First Quarter of 2008
Compared with the First Quarter of 2007
  The decrease in
UniSource Energy’s net income in the first three months of 2008 is due primarily
to higher purchased power expenses and an increase in coal-related fuel
expense.   Planned and unplanned outages at TEP’s coal-fired
generating plants and higher wholesale energy prices lead to higher replacement
power costs.  In addition, coal-related fuel expense was $6 million
higher than last year due to higher commodity prices and increased output from
TEP's higher cost plants, despite a slight decline in generating
output.  See Tucson
Electric Power Company, Results of Operations,below,andTucson Electric Power Company,
Liquidity and Capital Resources, Financing Activities,
below.
 
 37
 Table of Contents
 
 CONTRIBUTIONBY BUSINESS SEGMENT
 
 The table below
shows the contributions to our consolidated after-tax earnings by our three
business segments, as well as Other net income (loss).
 
 Three
      Months Ended
                March
      31,2008
              2007-Millions of
      Dollars-TEP
              $
      (9)
              $
      1UNS Gas
              6
              5UNS Electric
              1
              -Other (1)
              (1)
              (1)Consolidated
      Net (Loss) Income
              $
      (3)
              $
      5
  (1)Includes: UniSource Energy parent company expenses; UniSource Energy
parent company interest expense (net of tax) on the UniSource Convertible Senior
Notes and on the UniSource Credit Agreement; and income and losses from
Millennium investments.
 
 
 LIQUIDITYAND CAPITAL RESOURCES
 
 UniSource
Energy Consolidated Cash Flows
 
 Three  Months
      Ended March 31,
              2008
              2007-Millions of
      Dollars-Cash provided
      by (used in):Operating Activities
              $
      55
              $
      65Investing Activities
              (79)
              (41)Financing Activities
              29
              (33)
 
 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.  Cash used for investing activities is primarily a result of
capital expenditures at TEP, UNS Gas and UNS Electric.  Cash used for
financing activities can fluctuate year-to-year depending
on:  repayments and borrowings under revolving credit facilities; debt
issuances or retirements; capital lease payments by TEP; and dividends paid by
UniSource Energy to its shareholders.
 
 The primary source
of liquidity for UniSource Energy, the parent company, is dividends from its
subsidiaries, primarily TEP.  Also, under UniSource Energy’s tax
sharing agreement, subsidiaries make income tax payments to UniSource Energy,
which makes payments on behalf of the consolidated group.  The table
below provides a summary of the liquidity position of UniSource Energy on a
stand-alone basis and each of its segments.
 
 38
 Table of Contents
  Balances
      as of
                May
      7, 2008
              Cash
      and Cash
                Equivalents
              Borrowings
                under
      Revolving
                Credit Facility(1)
              Amount
      Available
                under
      Revolving
                Credit
      Facility-Millions of
      Dollars-UniSource
      Energy stand-alone
              $    2
              $ 
      39
              $  31TEP
              23
              5
              145UNS
      Gas
              20
              -
              45(2)UNS
      Electric
              5
              30
              15(2)Other
              32(3)
              -
              -Total
              $ 82
 
 (1)Includes LOCs issued under Revolving Credit Facilities
 
 (2)Either
UNS Gas or UNS Electric may borrow up to a maximum of $45 million, but the total
combined amount borrowed cannot exceed $60
 million.
 
 (3)Includes cash and cash equivalents at Millennium.
 
 Executive
Overview
 
 Operating
Activities
 
 In
the first three months of 2008, net cash flows from operating activities were
$10 million lower than the same period in 2007.  The decrease is due
primarily to higher fuel and purchased power costs at TEP.
 
 Investing
Activities
 
 Net cash used for
investing activities was $37 million higher in the first three months of 2008
compared with the same period in 2007, due to an increase in capital
expenditures.  Capital expenditures were higher in the first three
months of 2008 due primarily to higher levels of utility system growth and
maintenance.
 
 Financing
Activities
 
 Net cash flows from
financing activities were $62 million higher in the first three months of 2008
compared with the same period in 2007.  In March 2008, The Industrial
Development Authority of Pima County issued, for the benefit of TEP,
approximately $91 million of tax-exempt industrial development revenue bonds
(IDBs).  This increase in cash flows was offset by higher scheduled
payments on capital lease obligations by TEP and lower net borrowings on
revolving credit facilities.
 
 Liquidity
Outlook
 
 As
a result of growing capital expenditures at UniSource Energy’s subsidiaries, the
revolving credit facilities at UniSource Energy, TEP, UNS Gas and UNS Electric
may be used on a more frequent basis.  Other funding sources to meet
the capital requirements of the strong utility customer growth could include the
issuance of long-term debt, as well as capital contributions from UniSource
Energy to its subsidiaries.The need for
external funding sources is partially dependent on the outcome of rate-related
proceedings at TEP, UNS Gas and UNS Electric.
 
 In
August 2008, TEP and UNS Electric will have long-term maturities of $138 million
and $60 million, respectively.  Both companies expect to refinance the
maturing debt with new debt issuances prior to August 2008.
 
 For more
information concerning liquidity and capital resources, see Tucson Electric Power Company,
Liquidity and Capital Resources, below, UNS Gas, Liquidity and Capital
Resources, UNS
Electric, Liquidity and Capital Resources,andOther Non-Reportable Segments,
Liquidity and Capital Resources, below.
  39
 Table of Contents
 UniSource Energy Credit
Agreement
 
 The UniSource
Credit Agreement consists of a $30 million amortizing term loan facility and a
$70 million revolving credit facility and matures in 2011.  At March
31, 2008, there was $20 million outstanding under the term loan facility and $34
million outstanding under the revolving credit facility at a weighted average
interest rate of 3.99%.
 
 Convertible Senior
Notes
 
 UniSource Energy
has outstanding $150 million of 4.50% Convertible Senior Notes due
2035.  Each $1,000 of Convertible Senior Notes is convertible into
26.6667 shares of our Common Stock at any time, representing a conversion price
of approximately $37.50 per share of our Common Stock, subject to adjustment in
certain circumstances.  The closing price of UniSource Energy’s Common
Stock was $30.26 on May 7, 2008.
 
 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, 2008 were:
 
 ·
              UES’
      guarantee of senior unsecured notes issued by UNS Gas ($100 million) and
      UNS Electric ($60 million);
 ·
                UES’
      guarantee of the $60 million UNS Gas/UNS Electric
  Revolver;
 ·
              UniSource
      Energy’s guarantee of approximately $2 million in building lease payments
      for UNS Gas.
 
 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 UES would be required to
perform or otherwise incur any significant losses associated with any of these
guarantees or indemnities is remote.
 
 Contractual
Obligations
 
 There have been no
significant changes in our contractual obligations or other commercial
commitments from those reported in our 2007 Annual Report on Form 10-K, other
than:
 
 ·
              In March and
      April 2008, TEP entered into additional power supply agreements for the
      periods June through September 2008 and 2009.  Some of these
      contracts are indexed to natural gas prices.  TEP estimates its
      minimum payments under these contracts to be $58 million in 2008 and $9
      million in 2009 based on natural gas prices at March 31,
    2008.
 
 ·
              In March
      2008, TEP entered into a five year gas transportation agreement with El
      Paso Natural Gas.  TEP estimates its minimum payments under this
      contract to be $3 million in each of 2008 and 2009, $4 million in each of
      2010 through 2012, and less than $1 million in
  2013.
 
 ·
              In March
      2008, TEP entered into additional forward gas purchase agreements through
      April 2011.  TEP estimates its minimum payments for these
      forward purchases to be $13 million in 2008 and approximately $1 million
      in each of 2009 and 2010.
 
 ·
              In 2008, UNS
      Electric entered into forward gas purchase agreements through February
      2011.  UNS Electric estimates its minimum payments for these
      forward purchases to be less than $1 million in each of 2008 through 2011
      based on natural gas prices at March 31,
2008.
  40
 Table of Contents
 
 ·
              In March
      2008, UNS Gas entered into forward gas purchase agreements through April
      2011.  UNS Gas estimates its minimum payments for these forward
      purchases to be $2 million in 2008, $4 million in 2009, and approximately
      $1 million in each of 2010 and 2011 based on natural gas prices at March
      31, 2008.
 
 The total amount
paid under these contracts depends on the quantity purchased and/or
transported.  TEP, UNS Electric and UNS Gas requirements are expected
to be in excess of these minimums.
 
 
 Dividends
on Common Stock
 
 The following table
shows the dividends declared to UniSource Energy shareholders for
2008:
 
 Declaration
      Date
              Record
      Date
              Payment
      Date
              Dividend
      Amount
                Per
      Share of Common StockFebruary 27,
      2008
              March 10,
      2008
              March 21,
      2008
              $0.24May 1,
      2008
              May 13,
      2008
              May 27,
      2008
              $0.24
 
 
 Income
Tax Position
 
 At
March 31, 2008, UniSource Energy and TEP had, for federal and state income tax
filing purposes: AMT credit carryforward amounts of $38 million and $24 million,
respectively; and a $4 million Capital Loss carryforward at UniSource
Energy.
 
 
 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.
 
 Three
Months Ended March 31
 
 TEP recorded a net
loss of $9 million in the first quarter of 2008 compared with net income of $1
million in the same period last year.  The following factors
contributed to the decrease:
  ·
                a $12 million
      decrease in total operating revenues less fuel and purchased power expense
      due to the following:
 
 ·
                a $1 million
      increase in retail revenues due to customer
  growth;
 
 ·
                a $5 million
      increase in other revenues due primarily to fees and reimbursements
      received for fuel and O&M costs related to Springerville Units 3 and
      4.  O&M expense in the first quarter of 2007 includes a
      pre-tax gain of $2 million related to the sale of excess SO2 Emission
      Allowances;
 
 ·
                a $3 million
      increase in wholesale revenues due primarily to a 32% increase in the
      average market price of wholesale power;
and
 
 ·
                a $21 million
      increase in fuel and purchased power expense due to higher coal costs, a
      19% increase in generation from Luna using high cost natural gas and
      higher market prices for wholesale power and natural gas.  Fuel
      and purchased power expense in the first quarter of 2008 includes an
      increase of $2 million in unrealized losses on forward purchases of energy
      and gas.
  Other factors
impacting the comparability of first quarter 2008 results with 2007
include:
  ·
                  a $2 million
      increase in depreciation and amortization expense due to additions to
      plant in service;
  41
 Table of Contents
 
 ·
                  a $2 million
      increase in the amortization of TEP’s Transition Recovery Asset
      (TRA);
 
 ·
                  a $3 million
      decrease in total interest expense resulting primarily from lower balances
      on capital lease obligations.
 In
the first quarters of 2008 and 2007, the net pre-tax benefit recognized by TEP
related to Springerville Units 3 and 4 for operating fees, construction-related
expenses and a reduction in its share of the common costs was $5 million and $4
million, respectively.
 
 
 Utility
Sales and Revenues
 
 Sales
              
              
              Operating
      RevenueThree
      Months Ended March 31,
              
              2008
              
              
              2007
              
              
              2008
              
              
              2007-Millions of
      kWh-
              
              
              -Millions of
      Dollars-Electric
      Retail Sales:Residential
              
              
              773
              
              
              
              774
              
              
              $
              65
              
              
              $
              65Commercial
              
              
              415
              
              
              
              415
              
              
              
              42
              
              
              
              42Industrial
              
              
              518
              
              
              
              531
              
              
              
              36
              
              
              
              37Mining
              
              
              266
              
              
              
              239
              
              
              
              14
              
              
              
              12Public Authorities
              
              
              55
              
              
              
              53
              
              
              
              4
              
              
              
              4Total
      Electric Retail Sales
              
              
              2,027
              
              
              
              2,012
              
              
              $
              161
              
              
              $
              160Electric
      Wholesale Sales Delivered:Long-term Contracts
              
              
              311
              
              
              
              285
              
              
              
              15
              
              
              
              14Other Sales
              
              
              632
              
              
              
              550
              
              
              
              34
              
              
              
              32Transmission
              
              
              -
              
              
              
              -
              
              
              
              3
              
              
              
              3Total
      Electric Wholesale Sales
              
              
              943
              
              
              
              835
              
              
              
              52
              
              
              
              49Total Electric
    Sales
              
              
              2,970
              
              
              
              2,847
              
              
              $
              213
              
              
              $
              209Weather
      Data:
              
              2008
              
              
              2007Heating Degree
      DaysThree
      Months Ended March 31
              
              
              858
              
              
              
              91310-Year
      Average
              
              
              811
              
              
              
              825
 
 Mark-to-Market
Adjustments
 
 The table below
summarizes the net unrealized gains (losses) on TEP’s forward sales and
purchases of power and natural gas.  Amounts for 2008 are based on the
market price of power and natural gas as of March 31, 2008.
 
 Mark-to-Market
      Transactions – Gain (Loss) on:
              2008
              2007-Millions of
      Dollars-Forward Power
      Sales Recorded in Wholesale Sales
              $   
      (5)
              $   
      (9)Forward Power
      Purchases Recorded in Wholesale Sales
              4
              8Forward Power
      Purchases Recorded in Purchased Energy
              (3)
              -Forward Gas
      Price Swaps Recorded in Fuel
              1
              -Total
      Pre-Tax Unrealized Gain (Loss) Recorded in Earnings
              $   
      (3)
              $   
      (1)
 
 Operating
Expenses
 
 Fuel and Purchased Power
Expense
 
 TEP’s fuel and
purchased power expense and energy resources for the three months ended March
31, 2008 and 2007 are shown in the table below.
 
 42
 Table of Contents
 
 Generation
      and
                Purchased
      Power
              ExpenseThree
      Months Ended March 31,
              2008
              2007
              2008
              2007-Millions of
      kWh-
              -Millions of
      Dollars-Coal-Fired
      GenerationFour
      Corners
              150
              179
              $  
      3
              $ 3Navajo
              299
              290
              5
              4San
      Juan
              515
              493
              16
              12Springerville
              1,348
              1,418
              23
              24Sundt Unit
      4
              207
              164
              8
              6Total
      Coal-Fired Generation
              2,519
              2,544
              55
              49Gas-Fired
      GenerationLuna
              197
              166
              12
              9Other Gas
      Units
              3
              14
              1
              2Total
      Gas-Fired Generation
              200
              180
              13
              11Solar and
      Other
              2
              2
              -
              -Total
      Generation (1)
              2,721
              2,726
              68
              60Total
      Purchased Power
              430
              325
              32
              18Total
      Resources
              3,151
              3,051
              $100
              $78Less Line
      Losses and Company Use
              (181)
              (204)Total Energy
      Sold
              2,970
              2,847(1)Fuel expense in 2008
      and 2007 excludes $1 million related to Springerville 3; these expenses
      are reimbursed by Tri- State and recorded in Other
      Revenue.
 
 
 Coal-fired
generation decreased by 1% compared with the first quarter of 2007, due to an
increase in planned outages compared with last year.  Despite lower
generating output, coal-related fuel expense increased by $6 million, or 12%,
due primarily to higher coal costs at San Juan and Sundt Unit 4 and increased
output from TEP's higher cost plants.  See Coal Supply,below.
 
 Gas-fired
generation increased by 11% due primarily to lower coal plant availability.
Gas-related fuel expense was $2 million, or 18%, higher than the first quarter
of 2007 primarily due to higher generating output and a 15% increase in the
market price of natural gas.
 
 Power purchases
increased 32% compared with the first quarter of 2007, leading to a $14 million
increase in purchased power expense.  The higher purchased power
volume and expense is due primarily to replacement power purchases due to lower
coal plant availability, higher short-term wholesale sales activity and a 35%
increase in the market price for wholesale energy.
  Three
      Months Ended
                March
      31,2008
              2007-cents per
      kWh-Coal
              2.18
              1.93Gas
              6.50
              6.11All
      Fuels
              2.50
              2.20All
      sources
              3.18
              2.56
 
 43
 Table of Contents
 
 FACTORSAFFECTING RESULTS OF OPERATIONS
 
 TEP
Rate Proceeding
 
 Beginning in May
2005, TEP filed a series of pleadings requesting the ACC to resolve the
uncertainty surrounding the methodology that will be applied to determine TEP’s
rates for generation service after 2008.  TEP filed the pleadings in
response to the Arizona Court of Appeals’ ruling related to retail competition
and market pricing and a lack of agreement by a number of participants in TEP’s
rate proceedings on rate methodology after 2008.  TEP believes that
the 1999 Settlement Agreement contemplated market based rates for generation
service after 2008; other participants, including ACC Staff, disagree and have
stated that the 1999 Settlement Agreement does not control how TEP’s rates for
generation service will be established after 2008.
 
 TEP Rate
Proposals
 
 In
accordance with an ACC order, TEP filed three rate proposal methodologies
(market, hybrid and cost-of-service) with the ACC in July 2007, to establish new
rates for TEP when the existing rate increase moratorium of the 1999 Settlement
Agreement is lifted on January 1, 2009.  The estimated average rate
increases under the three methodologies ranged from 15% to 23%.
 
 Proposed Settlement
Agreement
 
 TEP and ACC Staff
have agreed in principle to the major terms of a settlement in the TEP rate
proceeding.  TEP and the ACC Staff will commence the process of
preparing a definitive settlement agreement, which is expected to be filed with
the ACC.  There can be no assurance that a definitive settlement
agreement will be reached or whether other participants in the rate proceeding
will support the proposed settlement.  The proposed rates will be more
fully developed in connection with the preparation of a definitive settlement
agreement and may vary from those described below. A settlement agreement would
also be subject to a hearing before the administrative law judge and approval by
the ACC.
  As
a result of the proposed settlement agreement between TEP and ACC staff, an
administrative law judge (ALJ) issued a procedural order on May 12, 2008.
 The procedural schedule is as follows:
  DateTEP and ACC
      staff file written settlement agreement
                May 29,
      2008Testimony
      from intervenors supporting the settlement agreement
                June 11,
      2008Testimony
      from intervenors opposing the settlement agreement
                July 2,
      2008Rebuttal
      testimony from intervenors supporting the settlement
    agreement
                July 8,
      2008Hearings
      before ALJ
                July 9,
      2008
  As
currently contemplated, the settlement would provide for a cost of service rate
methodology for TEP’s generation assets; a base rate increase of 6% over TEP’s
current retail rates; the fuel rate included in base rates would be 2.9 cents
per kilowatt-hour (kWh); a PPFAC effective January 1, 2009; a base rate
moratorium through January 1, 2013; and a waiver of any claims under the 1999
Settlement Agreement.
 
 The settlement
contemplates that the ACC would establish the date that the base rate increase
would go into effect.
 
 All of TEP's rights
and claims under the 1999 Settlement Agreement would be waived if the proposed
settlement agreement is approved by the ACC without any significant
modifications.  If TEP does not receive adequate rate relief from the
ACC:  (i) all of TEP's legal rights and claims arising out of the 1999
Settlement Agreement and the decision approving the 1999 Settlement Agreement
would be fully preserved; (ii) TEP's results of operations, net income and cash
flows could be negatively impacted; and (iii) TEP may initiate legal proceedings
against (a) the ACC, and other parties, for breach of the 1999 Settlement
Agreement and (b) the ACC for inadequate rates.  The proposed settlement
agreement is subject to ACC approval.  TEP cannot predict the outcome of
the rate case proceedings.
 
 Proposed Purchased Power and
Fuel Adjustment Clause
 
 The proposed
settlement agreement includes a PPFAC effective January 1, 2009.  The
PPFAC would be based on the form proposed in the testimony filed by the ACC
Staff on February 29, 2008 except that 100% of TEP’s wholesale revenues from
short term sales and 50% of the revenues from the sale of SO2 allowances would be credited
against TEP’s purchased power and fuel expense.
 
 As
proposed, the PPFAC consists of a forward component and a true-up
component.
 
 Effective January
1, 2009 with the PPFAC rate initially set to zero through March 31,
2009.  Year one for the PPFAC will be from April 1, 2009 through March
31, 2010.  The first True-Up component will include  the
period of January 1, 2009 through March 31, 2010.
 
 ·
              Forward
      Component.  This component would be updated April 1of
      each year and will be the forecasted fuel and purchased power cost for the
      coming April 1 to March 31 PPFAC year less the base cost of fuel and
      purchased power reflected in base rates (2.9 cents per
    kWh).
 
 ·
              True-Up
      Component. This component would reflect the difference between actual fuel
      and purchase power costs with the amount TEP collected through both base
      rates and the PPFAC rate in a given PPFAC year.  If actual costs
      were above (below) what was collected, the True-Up Component would be
      charged (credited) to customers in the subsequent PPFAC
    year.
  44
 Table of Contents
 True-up
Revenues
 
 According to a May
2007 order of the ACC, TEP’s current retail rates shall remain in effect,
including the collection of an amount equal to the Fixed Competitive Transition
Charge (CTC), until the effective date of a final order in the rate case
proceeding.  The incremental revenues (true-up revenues) collected as
a result of continuing to collect an amount equal to the Fixed CTC after it
would otherwise terminate under the 1999 settlement (estimated to be $65 million
from June 1, 2008 to December 31, 2008) shall accrue interest and shall be
subject to refund or credit or other such mechanism to protect customers, as
determined by the ACC.
 
 The proposed
settlement does not address the amount or the treatment of any true-up revenues
but would provide, to the extent the ACC determines that the true-up revenues
are to be credited to customers, that TEP will credit up to $32.5 million of
true-up revenue to customers through the PPFAC.
 
 Fixed
CTC and Incremental Revenue
 
 The Fixed CTC would
otherwise terminate when the TRA balance is amortized to zero (approximately May
2008).  From January 1, 2008 to approximately May 31, 2008, TEP
expects to record Fixed CTC revenues of approximately $28 million and
amortization expense of approximately $24 million related to the
TRA.  In 2007, TEP recorded $78 million of amortization expense
related to the TRA.  After the expiration of the Fixed CTC, TEP does
not expect to record any similar revenues or expense until or unless the ACC
issues a final order that authorizes TEP to retain any incremental
revenues.
 
 Renewable
Energy Standard and Tariff
 
 In
April 2008, the ACC approved a REST plan for TEP to be implemented starting on
June 1, 2008.  The plan is based on an ACC Staff recommendation that
will result in $14 million collected annually from customers to pay for REST
compliance costs.  The funds received from customers under the REST
plan will not impact TEP’s income statement, as the amounts collected will be
used to offset costs incurred by TEP under the REST plan.
 
 FERC
Proceeding
 
 TEP is a party to a
proceeding pending at FERC involving the interpretation of the 1982
Power Exchange and Transmission Agreement (1982 Agreement) between TEP and
El Paso Electric (El Paso).  The dispute relates to TEP’s ability to use
existing rights for the transmission of power from Luna to TEP’s
system.    On September 6, 2007, a FERC ALJ issued an
initial decision, subject to full FERC review, that supports TEP’s
position.
 
 As
part of this proceeding, TEP has requested that FERC order El Paso to
refund transmission charges paid by TEP during the pendency of this dispute
proceeding. These refunds include $3.5 million paid to El Paso
in 2006, $3 million paid to El Paso in 2007, $1 million in the first
quarter of 2008, as well as any additional disputed transmission purchased prior
to FERC issuing its final order.  TEP expects FERC to issue its final order
in 2008.
  TEP cannot
predict the outcome of this proceeding.
 
 45
 Table of Contents
 
 Market
Prices
 
 As
a participant in the Western U.S. wholesale power markets, TEP is directly and
indirectly affected by changes in market conditions.  The average
market price for around-the-clock energy based on the Dow Jones Palo Verde Index
was 35% higher in the first quarter of 2008 compared with the same period last
year.  The average price for natural gas based on the Permian Index
was 16% higher than the first quarter of 2007.  We cannot predict
whether changes in various factors that influence demand and supply will cause
prices to change for the remainder of 2008.
 
 Average
      Market Price for Around-the-Clock Energy
              $/MWhQuarter ended March 31,
    2008
              $66Quarter ended March 31,
    2007
              49Average
      Market Price for Natural Gas
              $/MMBtuQuarter ended March 31,
      2008
              $7.30Quarter ended March 31,
      2007
              6.32
 
 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 47% of this exposure hedged
for the summer peak period of 2008 (June – September) at a weighted average
price of $8.39 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 2008, TEP has sold forward approximately 176,000 MWh at an
average price of $66 per MWh.
 
 Coal
Supply
 
 We
expect TEP’s total coal-related fuel expense across all of its plants to
increase by $18 million in 2008, compared with 2007.  Excluding the $8
million of settlement benefits and year-end adjustments related to mining costs
at San Juan recognized in the fourth quarter of 2007, general cost pressures are
expected to increase total coal-related fuel expense by $10 million, or 5% in
2008.
 
 Generating
Plant Operating Performance
 
 In
February 2008, Springerville Unit 1 incurred a partial collapse of one of four
scrubber modules.  Structural inspections revealed that repairs were
required on various scrubber modules on both Springerville Units 1 and
2.  The generating capacity of Springerville Units 1 and 2 are 380 MW
and 390 MW, respectively.  During the inspection period in February
and March 2008, the output of Springerville Units 1 and 2 were each reduced by
10-15 MW.
 
 The repair work was
completed on Unit 1 in early May and repairs are expected to be completed on
Unit 2 in June 2008.  During the module repair process, the output
from Springerville Unit 2 has been reduced by 10 MW.  TEP expects a
significant portion of the repair costs to be covered by insurance.
 
 Emission
Allowances
 
 TEP has SO2 Emission
Allowances in excess of what is required to operate its generating
units.  The excess results primarily from a higher removal rate of
SO2
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
SO2
Emission Allowances.  The table below summarizes sales of SO2 Emission
Allowances made in 2007.  TEP did not sell any SO2 Emission
Allowances in the first quarter of 2008 and had no forward sales as of March 31,
2008.
 
 46
 Table of Contents
 
 Delivery
              Allowances
      Sold
              Pre-tax
      Gain2007
              
              - Millions of
      Dollars -1st
      Quarter
              2,500
              $
      22nd
      Quarter
              7,500
              53rd
      Quarter
              5,000
              34th
      Quarter
              7,000
              5Total
      2007
              22,000
              $15
 
 TEP expects to have
approximately 14,000 excess SO2 Emission
Allowances through 2009.  Existing regulations call for changes to the
EPA SO2 Emissions Allowances allocation beginning in 2010.  As a
result, beginning in 2010, TEP’s SO2 Emissions Allowances allocations will
slightly decrease.  In addition, TEP expects the market for SO2
Emissions Allowances to change and their value to decline.
 
 Fair
Value Measurements
 
 As
described in Note 10 to the financial statements, TEP adopted FAS 157, Fair Value Measurements, on
January 1, 2008 which, among other things, establishes a three-tier value
hierarchy, based on the valuation techniques used to determine the fair value of
derivative assets and liabilities.  Where valuations are based on
quoted prices in active markets these are categorized as Level
1.  Where observable inputs are available for substantially the full
terms of the asset or liability, the instrument is categorized under FAS 157 as
Level 2 measurements.  Derivatives that are primarily valued using an
aggregate pricing service or published prices that represent a consensus
reporting of multiple brokers are categorized in Level 3.  In
addition, complex or structured transactions can introduce the need for
internally-developed model inputs that might not be observable in or
corroborated by the market. When such inputs have a significant impact on the
measurement of fair value, the instrument is categorized under FAS 157 as Level
3 measurements.
 
 The following table
sets forth, by level within the fair value hierarchy, TEP’s financial assets and
liabilities that were accounted for at fair value on a recurring basis as of
March 31, 2008.  As required by FAS 157, financial assets and
liabilities are classified in their entirety based on the lowest level of input
that is significant to the fair value measurement.
 
 Tucson
      Electric PowerMarch
      31, 2008
                - Millions of
      Dollars -Quoted Prices
      in
                Active
      Markets
                for
      Identical
                Assets (Level
      1)
              Significant
      Other
                Observable
                Inputs (Level
      2)
              Significant
                Unobservable
                Inputs (Level
      3)
              TotalEnergy
      Contracts (1)
              $        
      -
              $        
      16
              $       
      17
              $       
      33Cash
      Collateral (2)
              -
              1
              -
              1Investments
      (3)
              -
              13
              -
              13Deferred
      Compensation
              -
              (5)
              -
              (5)Interest Rate
      Swap
              -
              (5)
              -
              (5)Total
              $        
      -
              $       
      20
              $       
      17
              $       
      37
 
 (1) Energy
Contracts include forward power purchase and sales contracts, gas swap
agreements and forward power purchase contracts indexed to gas, entered into to
take advantage of favorable market conditions and reduce exposure to energy
price risk.
 (2) Cash Collateral
relates to the payment of cash as collateral against the fair value of TEP's
trading derivatives.
 (3) Investments are
amounts held in trust to fund deferred compensation and Supplemental Executive
Retirement Plan benefits.
  TEP recorded
unrealized losses of $3 million in Purchased Energy line of the income statement
and $1 million in Other Comprehensive Income (OCI) due to the change in the fair
value of net trading derivatives classified as Level 3 in the fair value
hierarchy.  These changes in fair value were due to higher gas prices
on gas-indexed forward power purchases.
 
 TEP’s Level 3
derivatives include certain energy contracts where published prices are not
readily available.  These include contracts for delivery periods
during non-standard time blocks and contracts for delivery during only a few
months of a given year when prices are quoted only for the annual
average.  In these cases, TEP applies certain assumptions using
historical price curve relationships to value such contracts.  There
were no changes in such valuation methods in the first quarter of
2008.
  47
 Table of Contents
  Regional
Haze
 
 The EPA's regional
haze rules require emission controls known as Best Available Retrofit
Technology (BART) for certain industrial facilities emitting air pollutants that
reduce visibility.  The operators of the Four Corners, Navajo, and San
Juan generating stations submitted BART analyses in 2007 and early
2008.  PNM, operator of San Juan, believes the controls being
installed at San Juan as a result of the 2005 settlement agreement between PNM,
environmental activist groups, and the New Mexico Environment Department (PNM
Consent Decree) constitute BART and did not recommend installation of any
additional pollution control equipment.  The operators
of the Four Corners and Navajo generating stations recommended
installing certain additional pollution control equipment in their respective
BART analyses.  The level and cost of pollution control required, if
any, will not be known until the plans are approved by the regulatory
agencies.  If required, controls would need to be in place by 2013 or
later.
  LIQUIDITYAND CAPITAL RESOURCES
 
 TEP
Cash Flows
 
 During 2008, TEP
expects to generate sufficient internal cash flows to fund a portion of its
construction expenditures as well as operating activities, required debt
maturities and dividends to UniSource Energy.  Cash flows may vary
during the year, with cash flow from operations typically the lowest in the
first quarter and highest in the third quarter due to TEP’s summer peaking
load.   As a result of the varied seasonal cash flow, TEP will
use, as needed, its revolving credit facility to fund its business
activities.
 
 The table below
shows TEP’s net cash flows after capital expenditures, scheduled debt payments
and payments on capital lease obligations which are paid at the beginning of
January and July:
 
 Three
      Months Ended March 31,
              2008
              2007-Millions of
      Dollars-Net Cash
      Flows – Operating Activities (GAAP)
              $ 
      56
              $ 
      50Amounts from
      Statements of Cash Flows:Less: Capital
      Expenditures
              (74)
              (34)Net Cash
      Flows after Capital Expenditures (non-GAAP)*
              (18)
              16Amounts from
      Statements of Cash Flows:Less: Retirement of Capital Lease
      Obligations
              (62)
              (56)Plus: Proceeds from Investment in Lease
      Debt
              11
              11Net Cash
      Flows after Capital Expenditures and Required Payments
                on Debt and
      Capital Lease Obligations (non-GAAP)*
              $
      (69)
              $
      (29)
 
 Three
      Months Ended March 31,
              2008
              2007-Millions of
      Dollars-Net Cash
      Flows – Operating Activities (GAAP)
              $  
      56
              $   
      50Net Cash
      Flows – Investing Activities (GAAP)
              (63)
              (26)Net Cash
      Flows – Financing Activities (GAAP)
              18
              (10)Net Cash
      Flows after Capital Expenditures (non-GAAP)*
              (18)
              16Net Cash
      Flows after Capital Expenditures and Required Payments
                on Debt and
      Capital Lease Obligations (non-GAAP)*
              (69)
              (29)
 
 *
Net Cash Flows after Capital Expenditures and Net Cash Flows after Required
Payments, both non-GAAP measures of liquidity, should not be considered as
alternatives to Net Cash Flows - Operating Activities, which is determined in
accordance with GAAP as a measure of liquidity.  We believe that Net
Cash Flows after Capital Expenditures and Net Cash Flows after Required Payments
provide useful information to investors as measures of TEP’s liquidity and
ability to fund capital requirements, make required payments on debt and capital
lease obligations and pay dividends to UniSource Energy.
 
 Liquidity
Outlook
 
 As
a result of growing capital expenditures, TEP may use its revolving credit
facility on a more frequent basis.  Other funding sources to meet the
capital requirements from TEP’s strong customer growth could include the
issuance of long-term debt as well as capital contributions from UniSource
Energy.  The need for external funding sources is partially dependent
on the outcome of TEP’s rate proceedings.
 
 In
August 2008, $138 million of TEP mortgage bonds with a coupon of 7.5% will
mature.  TEP expects to refinance the maturing debt with a new debt
issuance prior to August 2008.  See Financing Activities, Bond
Issuances, below.
 
 48
 Table of Contents
 Operating
Activities
 
 In
the first three months of 2008, net cash flows from operating activities
increased by $6 million compared with the same period in 2007.  Net
cash flows were impacted by:
 ·
              a $13 million
      decrease in cash receipts from retail and wholesale electric sales, less
      fuel and purchased power costs, resulting from mild weather compared to
      last year and unplanned outages that limited wholesale sales
      opportunities;
 
 ·
              a $4 million
      increase in cash receipts related to reimbursements received for the
      operation of Springerville Units 3 and
4;
 
 ·
              income tax
      refunds of $6 million;
 
 ·
              a $2 million
      decrease in proceeds from the sale of excess SO2 emission
      allowances;
 
 ·
              a $6 million
      decrease in total interest paid due to lower capital lease obligation
      balances;
 
 ·
              a $7 million
      decrease in income taxes paid due to lower taxable income and payments
      made last year for amended tax returns;
and
 
 ·
              a $9 million
      increase in O&M costs related to Springerville Units 3 and 4 that are
      reimbursed to TEP and generating plant outage-related
    costs.
 
 Investing
Activities
 
 Net cash used for
investing activities was $37 million higher in the first three months of 2008
compared with the same period last year primarily due to higher capital
expenditures.
 
 Financing
Activities
 
 Net cash proceeds
from financing activities were $28 million higher in the first three months of
2008 compared with the same period in 2007.  The following factors
contributed to the increase:
 
 ·
              proceeds of
      $91 million received by TEP related to the issuance of tax-exempt IDB’s
      through Pima County;
 
 ·
              a $55 million
      decrease in net proceeds from borrowings under the TEP Revolving Credit
      Facility; and
 
 ·
              a $6 million
      increase in scheduled payments made on capital lease
      obligations.
 
 TEP Credit
Agreement
 
 The TEP Credit
Agreement consists of a $150 million revolving credit facility and a $341
million letter of credit facility which supports $329 million of tax-exempt
variable rate bonds.  The TEP Credit Agreement matures in 2011 and is
secured by $491 million of 1992 Mortgage Bonds.  At March 31, 2008,
there were no outstanding loans under the revolving credit facility and there
were $5 million in letters of credit issued under the revolving credit
facility.
 
 Bond
Issuance
 
 On
March 19, 2008, The Industrial Development Authority of the County of Pima (Pima
Authority) issued approximately $91 million of its 2008 Series A tax-exempt IDBs
(2008 Pima Series A IDBs) for TEP’s benefit.  The proceeds were used
to redeem a corresponding principal amount of bonds previously issued by the
Pima Authority for TEP’s benefit which TEP repurchased in 2005.  TEP
did not cancel the repurchased bonds, which remained outstanding under their
respective indentures but were not reflected as debt on the balance
sheet.   As holder of the repurchased bonds being redeemed, TEP
received the payment of the redemption price.  TEP used $75 million of
the proceeds to repay loans outstanding under its revolving credit facility; on
May 16, 2008, the remaining proceeds will be used to redeem $10 million of TEP’s
collateral trust bonds that mature in August 2008.
 
 The 2008 Pima
Series A IDBs bear interest at the rate of 6.375%, are payable semi-annually on
September 1 and March 1 of each year, beginning September 1, 2008, and mature on
September 1, 2029.  The 2008 Pima Series A IDBs are unsecured and are
callable at par in March 2013.
  49
 Table of Contents
 
 Letter of Credit
Facility
 
 On
April 30, 2008, TEP completed a $133 million three-year letter of credit
facility.  The facility permits the issuance of a letter of credit to
support $130 million in tax-exempt variable rate IDBs that TEP plans to issue by
August 1, 2008 to refinance IDBs currently held by TEP.  The proceeds of
the newly issued IDBs will be used to redeem the IDBs held by TEP.  TEP
expects to apply the redemption price received by it to retire the remaining
$128 million of 7.5% collateral trust bonds that mature on August 1, 2008. 
The letter of credit facility will be secured by mortgage bonds at the time of
issuance of the IDBs and the letter of credit.
 Capital Lease
Obligations
 
 At
March 31, 2008, TEP had $535 million of total capital lease obligations on its
balance sheet.  The table below provides a summary of the outstanding
lease amounts in each of the obligations.
 Leased
      Asset
              Capital
      Lease Obligation Balance
                at
      March 31, 2008
              Expiration- In Millions
      -Springerville
      Unit 1
              $301
              2015Springerville
      Coal Handling Facilities
              102
              2015Springerville
      Common Facilities
              106
              2020Sundt Unit
      4
              26
              2011Total Capital
      Lease Obligations
              $535
 
 Except for TEP’s
14% equity ownership in the Springerville Unit 1 Leases and its 13% equity
ownership in the Springerville Coal Handling Facilities, TEP will not own these
assets at the expiration of the leases.  TEP will either 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 Springerville Common
Facilities.
 
 Investments in Springerville
Lease Debt and Equity
 
 At
March 31, 2008, TEP had $141 million of investments in lease debt and equity on
its balance sheet.  TEP’s investment in lease debt has been reduced by
scheduled payments on capital lease obligations. The yields on TEP’s investments
in Springerville lease debt, at the date of purchase, range from 8.9% to
12.7%.  The table below provides a summary of the investment balances
in lease debt.
 
 Lease
      Debt Investment BalanceLeased
      Asset
              March
      31, 2008
              December
      31, 2007- In Millions
      -Investments
      in Lease Debt:Springerville
      Unit 1
              $
      59
              $ 
      71Springerville
      Coal Handling Facilities
              34
              34Total
      Investment in Lease Debt
              $
      93
              $105
 
 Income
Tax Position
 
 See UniSource Energy, Liquidity and
Capital Resources, Income Tax Position, above.
 
 Contractual
Obligations
 
 There have been no
significant changes in TEP’s contractual obligations or other commercial
commitments from those reported in our 2007 Annual Report on Form 10-K, other
than the TEP contracts discussed in UniSource Energy, Liquidity and
Capital Resources, Contractual Obligations.
 
 Dividends
on Common Stock
 
 There are certain
limitations on TEP’s ability to pay dividends.  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.
 
 TEP can pay
dividends if it maintains compliance with the TEP Credit Agreement and certain
financial covenants.  As of March 31, 2008, TEP was in compliance with
the terms of the TEP Credit Agreement and such financial covenants.
 
 50
 Table of Contents
 
 UNSGAS
 
 RESULTSOF OPERATIONS
 .
 UNS Gas reported
net income of $6 million in the first quarter of 2008 and $5 million in
2007.
 
 As
of March 31, 2008, UNS Gas’ customer base increased approximately 1% compared
with last year.  The table below shows UNS Gas’ therm sales and
revenues for the first quarters of 2008 and 2007.
 
 Sales
              RevenueThree
      Months Ended March 31,
              2008
              2007
              2008
              2007-
      Millions of Therms -
              -
      Millions of Dollars -Retail
      Therm Sales:Residential
              35
              34
              42
              $
      41Commercial
              12
              12
              13
              13Industrial
              1
              1
              1
              1Public
      Authorities
              3
              3
              4
              3Total
      Retail Therm Sales
              51
              50
              60
              58Transport
              -
              -
              1
              1Negotiated
      Sales Program (NSP)
              6
              5
              5
              3Total
      Therm Sales
              57
              55
              66
              $
      62
 
 Retail therm sales
were 2% higher in the first quarter of 2008 compared with the same period last
year due to customer growth.  Retail revenues were 3% higher due to a
base rate increase that went into effect in December 2007.   See
Factors Affecting Results of
Operations, Rates and Regulation, Purchased Gas Adjustment Mechanism,
below.
 
 Through a
Negotiated Sales Program (NSP) approved by the ACC, customers who receive gas
transmission services from UNS Gas may also elect to purchase gas from UNS
Gas.  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.
 
 The table below
provides summary financial information for UNS Gas.
 
 Three
      Months Ended March 31,
              2008
              2007- Millions of
      Dollars -Gas
      Revenues
              $
      65
              $
      62Other
      Revenues
              1
              1Total
      Operating Revenues
              66
              63Purchased Gas
      Expense
              45
              44Other
      Operations and Maintenance Expense
              6
              7Depreciation
      and Amortization
              2
              2Taxes other
      than Income Taxes
              1
              1Total
      Operating Expenses
              54
              54Operating
      Income
              12
              9Total
      Interest Expense
              2
              1Income Tax
      Expense (Benefit)
              4
              3Net
      Income
              $ 
      6
              $ 
      5
 
 51
 Table of Contents
 
 FACTORSAFFECTING RESULTS OF
OPERATIONS
 
 RATES
AND REGULATION
 
 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 is deferred and recovered or repaid to customers
through the PGA mechanism.
 
 The current 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.  In November 2007, the ACC increased
the annual cap on the maximum increase in the PGA factor from $0.10 per therm to
$0.15 per therm in a twelve month period.    In addition,
the ACC set the base cost of gas at zero, so that the entire cost of gas
will be reflected in the PGA factor.  Previously, the base cost of gas
was $0.40 per therm.
 
 At
any time UNS Gas’ PGA bank balance is under-recovered, UNS Gas may request a PGA
surcharge with the goal of collecting the amount deferred from customers over a
period deemed appropriate by the ACC.  When the PGA bank balance
reaches an over-collected balance of $10 million on a billed to customers basis,
UNS Gas is required to make a filing so that the ACC can determine how the
over-collected balance should be returned to customers.  On March 31,
2008, the PGA bank balance was over-collected by $1 million on a billed to
customers basis ($6 million on an accrual (GAAP) basis).
 
 Changes in the
market price for gas, sales volumes and surcharge amount could significantly
change the PGA bank balance in the future.
 
 2008 General Rate Case
Filing
 
 The rates approved
by the ACC in 2007 are inadequate for UNS Gas to recover capital and operating
costs related to providing safe and reliable service and earn a reasonable rate
of return on its investments.  On February 21, 2008, UNS Gas filed a
general rate case.  Below is a table that summarizes UNS Gas’
request:
 
 Test year
      ended
              September 30,
      2007Fair value
      rate base
              $236
      millionOriginal cost
      rate base
              $173
      millionRevenue
      deficiency
              $10
      millionTotal rate
      increase (over test year revenues)
              7%Cost of
      debt
              6.6%Return on
      Equity
              11.0%Hypothetical
      capital structure
              50% equity /
      50% debtWeighted
      average cost of capital
              8.8%Rate of
      return on fair value rate base
              7.3%Rate of
      return on original cost rate base
              9.9%
 
 UNS Gas proposed a
rate of return of 7.3% applied to its test year fair value rate base of $236
million.  This methodology is different from the approach the ACC used
in UNS Gas’ 2007 rate order.  UNS Gas believes that applying a rate of
return of 7.3% to its fair value rate base would give UNS Gas an opportunity to
earn its proposed return on equity of 11.0%.  UNS Gas’ proposed fair
value rate base methodology accounts for approximately $3 million of the $10
million revenue deficiency.
 
 In
March 2008, ACC staff informed UNS Gas that the historical test year used in its
general rate case filing did not meet ACC requirements and, as a result, the
filing by UNS Gas is deficient.  UNS Gas disagrees with the position
taken by the ACC staff and is seeking resolution of this issue.  The
ACC will not proceed with its review of UNS Gas’ general rate case until the
rate increase application is declared sufficient.  UNS Gas can not
predict when or if the ACC will consider its rate increase application
sufficient.
  52
 Table of Contents
 
 LIQUIDITYAND CAPITAL RESOURCES
 
 Liquidity
Outlook
 
 UNS Gas’ capital
requirements consist primarily of capital expenditures.  In the first
three months of 2008, capital expenditures were $4 million.  UNS Gas
expects internal cash flows to fund its future operating activities and a large
portion of its construction expenditures. If natural gas prices rise and UNS Gas
is not allowed to recover its projected gas costs or PGA bank balance on a
timely basis, UNS Gas may require additional funding to meet operating and
capital requirements.  Sources of funding future capital expenditures
could include draws on the UNS Gas/UNS Electric Revolver, additional credit
lines, the issuance of long-term debt, or capital contributions from UniSource
Energy.  The rate increase approved by the ACC in November 2007 covers
some, but not all, of UNS Gas’ higher costs and capital
investments.  UNS Gas may need to rely more heavily on external
funding sources for capital expenditures until it receives a decision in the
rate case filed in February 2008.
 
 Operating
Cash Flow and Capital Expenditures
 
 The table below
provides summary information for operating cash flow and capital expenditures
for the first three months of 2008 and 2007.
 
 Three
      Months Ended March 31,
              2008
              2007- Millions of
      Dollars -Net Cash
      Flows – Operating Activities
              $2
              $10Capital
      Expenditures
              4
              4
 
 UNS
Gas/UNS Electric Revolver
 
 The UNS Gas/UNS
Electric Revolver is a $60 million unsecured revolving credit facility which
matures in August 2011.  Either borrower may borrow up to a maximum of
$45 million so long as the combined amount borrowed does not exceed $60
million.
 
 UNS Gas expects to
draw upon the UNS Gas/UNS Electric Revolver from time to time for seasonal
working capital purposes, to fund a portion of its capital expenditures, or to
issue letters of credit to provide credit enhancement for its natural gas
procurement and hedging activities. As of May 7, 2008, UNS Gas had no
outstanding borrowings or letters of credit 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, 2008, 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.
 
 Contractual
Obligations
 
 In
March 2008, UNS Gas entered into forward gas purchase agreements through April
2011.  UNS Gas estimates it minimum payments for these forward
purchases to be $2 million in 2008, $4 million in 2009, and approximately $1
million in each of 2010 and 2011 based on natural gas prices at March 31,
2008.
 
 Dividends
on Common Stock
 
 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.
  53
 Table of Contents
 
 UNSELECTRIC
 
 RESULTSOF OPERATIONS
 
 UNS Electric
reported net income of $1 million in the first quarter of 2008 and net income of
less than $1 million in the first quarter of 2007.
 
 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, 2008, UNS Electric’s customer base increased approximately 1%
compared with last year.  The table below shows UNS Electric’s kWh
sales and revenues for the first quarters of 2008 and 2007.
 
 Sales
              RevenueThree
      Months Ended March 31,
              2008
              2007
              2008
              2007- Millions of
      kWh -
              - Millions of
      Dollars -Electric
      Retail Sales:Residential
              183
              181
              $18
              $18Commercial
              135
              131
              14
              14Industrial
              50
              47
              4
              4Other
              1
              1
              -
              -Total
      Electric Retail Sales
              369
              360
              $36
              $36
 
 Retail kWh sales
were 3% higher in the first quarter of 2008 compared with the same period last
year due primarily to customer growth.
 
 The table below
provides summary financial information for UNS Electric.
 
 Three
      Months Ended March 31,
              2008
              2007- Millions of
      Dollars -Electric
      Revenues
              $
      36
              $
      36Other
      Revenues
              1
              -Total
      Operating Revenues
              37
              36Purchased
      Energy Expense
              24
              24Other
      Operations and Maintenance Expense
              6
              6Depreciation
      and Amortization
              3
              3Taxes other
      than Income Taxes
              1
              1Total
      Operating Expenses
              34
              34Operating
      Income
              3
              2Total
      Interest Expense
              2
              2Income Tax
      Expense
              -
              -Net
      Income
              $ 
      1
              $  
      -
 
 
 FACTORSAFFECTING RESULTS OF OPERATIONS
 
 Rates
and Regulation
 
 General Rate Case
Filing
 
 UNS Electric’s
retail rates were last adjusted in August 2003.  As a result of
increased growth in UNS Electric’s service territory and the related increase in
capital expenditures and operating costs, such current rates are inadequate for
UNS Electric to recover its costs and earn a reasonable rate of return on its
investment.  In December 2006, UNS Electric filed a general rate
case.  In April 2008, the ALJ presiding over UNS Electric’s rate case
proceeding issued a recommendation, which is subject to approval by the
ACC.  Below is a table that compares UNS Electric’s request with the
ALJ recommendation:
 
 54
 Table of Contents
 
 Test year –
      12 months ended June 30, 2006
              Requested by
      UNS Electric
              ALJ
      RecommendationOriginal cost
      rate base
              $141
      million
              $131
      millionRevenue
      deficiency
              $8.5
      million
              $4
      millionTotal rate
      increase (over test year revenues)
              5.5%
              2.5%Cost of
      long-term debt
              8.2%
              8.2%Cost of
      equity
              11.8%
              10.0%Actual
      capital structure
              49% equity /
      51% debt
              49% equity /
      51% debtWeighted
      average cost of capital
              9.9%
              9.0%
 
 UNS Electric also
requested that the ACC approve the acquisition of the 90 MW BMGS combustion
turbine project under development by UED and include the cost of the project in
rate base effective June 1, 2008.   The cost of BMGS is expected
to be $60 million to $65 million.  The ALJ recommended that the ACC
deny UNS Electric’s request to include BMGS in rate base.  See Purchased Power Agreement,
below for more information.
 
 Energy Cost Adjustment
Mechanism
 
 UNS Electric’s
retail rates include a PPFAC, which allows for a separate surcharge or credit to
the base rate for delivered purchased power to collect or return under or over
recovery of costs.  UNS Electric’s PPFAC surcharge of approximately
1.825 cents per kWh was set to recover transmission costs and the cost of the
full-requirements power supply agreement with PWMT that expires May 31,
2008.
 
 As
part of the general rate case filing, UNS Electric requested that a new PPFAC
mechanism take effect beginning June 1, 2008, immediately following the
expiration of the current power supply agreement with PWMT, that would utilize a
forward looking projection of gas and purchased power costs, without any cap on
the amount the PPFAC could change over a give period.
 
 The PPFAC mechanism
proposed in the ALJ recommendation would have a forward component and a true-up
component.  The forward component of the PPFAC rate would be based on
forecasted fuel and purchased power costs. The true-up component would reconcile
actual fuel and purchased power costs with the amounts collected in the prior
year and any amounts under/over-collected would be collected/refunded from/to
customers.  The ALJ recommendation also imposes a cap on the
PPFAC rate of 1.73 cents per kWh, resulting in total fuel and purchased power
recovery of approximately 8.7 cents per kWh.  UNS Electric opposes a
cap on the forward component of the PPFAC rate since a cap could result in large
deferral amounts of fuel and purchased power costs and could challenge UNS
Electric’s ability to finance the deferred amounts until they can be collected
from customers.
 
 Procedural
Schedule
 
 The ALJ recommended
the new UNS Electric’s rates take effect June 1, 2008. UNS Electric expects the
ACC to rule on its rate case at the conclusion of an open meeting that is
scheduled for May 14, 2008.  UNS Electric cannot predict the outcome
of the rate case proceedings.
 
 Purchased
Power Agreement
 
 As
part of its rate case, UNS Electric has requested that the ACC approve the
transfer of the 90 MW BMGS from UED to UNS Electric and include the cost of the
project in rate base effective June 1, 2008.  Because BMGS was not
operational during the test year of UNS Electric’s rate case, the ALJ
recommended against this rate treatment.  As a contingency plan, in
the event that the ACC does approve the request, UED and UNS Electric have
entered into a Power Purchase and Sales Agreement (PPA) pursuant under which UED
would sell all the output of BMGS to UNS Electric over a five-year
term.  The PPA is a tolling arrangement in which UNS Electric takes
operational control of BMGS and assumes all risk of operation and maintenance
costs, including fuel.  Under the terms of the PPA, UNS Electric would
pay UED a capacity charge.  The PPA is subject to FERC
approval.
 
 On
April 24, 2008, the ACC authorized UNS Electric to defer the costs associated
with the PPA until they are addressed as part of UNS Electric’s pending general
rate case.  The ALJ has recommended that capacity charges incurred by
UNS Electric be recovered through UNS Electric’s PPFAC. UNS Electric expects
FERC to issue an order on the status of this PPA in May 2008.  See
Procedural Schedule,
above for expected timing of ACC action.
  55
 Table of Contents
 
 Renewable
Energy Standard and Tariff
 
 In
April 2008, the ACC approved a REST plan for UNS Electric to be implemented
starting on June 1, 2008.  The plan is based on an ACC Staff
recommendation that will result in approximately $3 million collected from
customers annually to pay for REST compliance costs.  The funds
received from customers under the REST plan will not impact UNS Electric’s
income statement, as the amounts collected will be used to offset costs incurred
by UNS Electric under the REST plan.
 
 Fair
Value Measurements
 
 UNS Electric
adopted FAS 157, Fair Value
Measurements, on January 1, 2008 which, among other things, establishes a
three-tier value hierarchy, based on the valuation techniques used to determine
the fair value of derivative assets and liabilities.  Where valuations
are based on quoted prices in active markets these are categorized as Level
1.  Where observable inputs are available for substantially the full
terms of the asset or liability, the instrument is categorized under FAS 157 as
Level 2 measurements.  Derivatives that are primarily valued using an
aggregate pricing service or published prices that represent a consensus
reporting of multiple brokers are categorized in Level 3.  In
addition, complex or structured transactions can introduce the need for
internally-developed model inputs that might not be observable in or
corroborated by the market. When such inputs have a significant impact on the
measurement of fair value, the instrument is categorized under FAS 157 as Level
3 measurements.
 
 The following table
sets forth, by level within the fair value hierarchy, UNS Electric’s financial
assets and liabilities that were accounted for at fair value on a recurring
basis as of March 31, 2008.  As required by FAS 157, financial assets
and liabilities are classified in their entirety based on the lowest level of
input that is significant to the fair value measurement.
 
 UNS
      ElectricMarch
      31, 2008
                - Millions of
      Dollars -Quoted Prices
      in
                Active
      Markets
                for
      Identical
                Assets (Level
      1)
              Significant
      Other
                Observable
                Inputs (Level
      2)
              Significant
                Unobservable
                Inputs (Level
      3)
              TotalEnergy
      Contracts
              $      -
              $3
              $21
              $25
 
 UNS Electric
recorded unrealized gains of $11 million in net Regulatory Liabilities due to
the change in the fair value of net trading derivatives classified as Level 3 in
the fair value hierarchy.  These changes in fair value were due to
higher forward power prices on fixed price forward power purchases.
 
 UNS Electric’s
level 3 derivatives include certain energy contracts where published prices are
not readily available.  These include contracts for delivery periods
during non-standard time blocks and contracts for delivery during only a few
months of a given year when prices are quoted only for the annual
average.  In these cases, UNS Electric applies certain assumptions
using historical price curve relationships to value such
contracts.  There were no changes in such valuation methods in the
first quarter of 2008
 
 
 LIQUIDITYAND CAPITAL RESOURCES
 
 Liquidity
Outlook
 
 In
the first three months of 2008, UNS Electric’s capital expenditures were $8
million.  UNS Electric expects internal cash flows to fund a portion
of its construction expenditures.  Additional sources of funding
future capital expenditures could include draws on the UNS Gas/UNS Electric
Revolver, additional credit lines, the issuance of long-term debt, or capital
contributions from UniSource Energy.  In April 2007, UniSource Energy
contributed $10 million of capital to UNS Electric.  The need for
external funding sources is partially dependent on the outcome of UNS Electric’s
general rate case that was filed in December 2006.  The ACC is
expected to rule on UNS Electric’s rate case at the conclusion of an open
meeting scheduled for May 14, 2008.
  56
 Table of Contents
 
 In
August 2008, $60 million of unsecured bonds with a coupon of 7.61% will
mature.  UNS Electric expects to refinance the maturing debt with a
new debt issuance prior to August 2008.  The rates and terms of such
new debt may be adversely affected depending on the timing and outcome of the
UNS Electric rate case decision.  See General Rate Case Filing,
above.
 
 
 Operating
Cash Flow and Capital Expenditures
 
 The table below
provides summary information for operating cash flow and capital expenditures
for the first three months of 2008 and 2007.
 
 Three
      Months Ended March 31,
              2008
              2007- Millions of
      Dollars -Net Cash
      Flows – Operating Activities
              $5
              $
      6Capital
      Expenditures
              8
              10
 
 
 UNS
Gas/UNS Electric Revolver
 
 See UNS Gas, Liquidity and Capital
Resources, UNS Gas/UNS Electric Revolver above for a 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, 2008, UNS Electric had $30 million
outstanding under the UNS Gas/UNS Electric Revolver at a weighted average
interest rate of 3.67%.
 
 Senior
Unsecured Notes
 
 UNS Electric has
$60 million of 7.61% senior unsecured notes due in August 2008 that are
guaranteed by UES. The note purchase agreement for UNS Electric contains 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, 2008, UNS
Electric was in compliance with the terms of its note purchase
agreement.  See Liquidity Outlook, above for
more information.
 
 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.
 
 Contractual
Obligations
 
 In
2008, UNS Electric entered into forward gas purchase agreements through February
2011.  UNS Electric estimates it minimum payments for these forward
purchases to be less than $1 million in each of 2008 through 2011 based on
natural gas prices at March 31, 2008.
 
 Dividends
on Common Stock
 
 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.
 
 57
 Table of Contents
 
 OTHERNON-REPORTABLE BUSINESS SEGMENTS
 
 RESULTSOF OPERATIONS
 
 The table below
summarizes the income (loss) for the Other non-reportable segments.
 
 Three
      Months Ended March 31,
              2008
              2007- Millions of
      Dollars -UniSource
      Energy Parent Company
              $(2)
              $(1)Millennium
      Investments
              1
              -UED
              -
              -Total Other
      Net Loss
              $(1)
              $(1)
 UniSource
Energy Parent Company
 
 UniSource Energy
parent company expenses include interest expense (net of tax) related to the
UniSource Energy Convertible Senior Notes and the UniSource Credit
Agreement.
 
 UED
 
 On-site
construction of the 90 MW BMGS in Kingman, Arizona began during the third
quarter of 2007 with an estimated completion date of May 2008 and, pending
regulatory approval, is expected to provide energy to UNS
Electric.  UED is financing the BMGS project with borrowings from
UniSource Energy under an inter-company note payable.  At March 31,
2008, there was $51 million outstanding and interest is payable quarterly at
LIBOR plus 1.25%.  The cost of BMGS is expected to be
$60 million to $65 million.  SeeUNS Electric,
Factors Affecting Results of Operation, Purchased Power Agreement, above.
 
 FACTORS
AFFECTING RESULTS OF OPERATIONS
 
 Millennium
Investments
 
 Nations Energy
Corporation (Nations Energy), a wholly-owned subsidiary of Millennium, has been
inactive since 2001.  As of March 31, 2008, Nations Energy had a
deferred tax asset of $3 million related to investment losses that has not been
reflected on UniSource Energy’s consolidated income tax return.
 
 Millennium is in
the process of exiting its remaining investments.  At March 31, 2008,
the book value of Millennium’s investments was $28 million.
 
 LIQUIDITY
AND CAPITAL RESOURCES
 
 Millennium made a
$5 million dividend payment to UniSource Energy in February 2007 and a $10
million dividend payment to UniSource Energy in April 2007.
 
 Millennium
currently owns 50% of Carboelectrica Sabinas, S. de R.L. de C.V. (Sabinas), a
Mexican limited liability company.  The book value of Sabinas as of
March 31, 2008 was $14 million.  Millennium is currently exploring
different opportunities to monetize its interest in Sabinas.
 
 UniSource Energy
has ceased making loans or equity contributions to Millennium.  We
anticipate that the funding required to finance 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’s Critical Accounting
Estimates are described in our Form 10-K for the year ended December 31, 2007
and includes the following:
  58
 Table of Contents
 
 ·
              Accounting
      for Rate Regulation
 ·
              Accounting
      for Asset Retirement Obligations
 ·
              Pension and
      Other Postretirement Benefit Plan
Assumptions
 ·
              Accounting
      for Derivative Instruments, Trading Activities and Hedging
      Activities
 ·
              Unbilled
      Revenue – TEP, UNS Gas and UNS
Electric
 ·
              Plant Asset
      Depreciable Lives – TEP, UNS Gas and UNS
  Electric
 ·
              Deferred Tax
      Valuation
 
 Each of our
critical accounting estimates involves complex situations requiring a high
degree of judgment either in the application and interpretation of existing
literature or in the development of estimates that impact the financial
statements.  There have been no significant changes in our accounting
policies from those disclosed in our Form 10-K for the year ended December 31,
2007.  However, the 2008 proposed settlement of the TEP rate
proceeding may result in TEP using cost-of service principles, thereby requiring
TEP to reapply FAS 71 for its generation operations.
  
 NEWACCOUNTING PRONOUNCEMENTS
 
 The FASB recently
issued the following Statements of Financial Accounting Standards
(FAS):
 
 ·
              FAS 161,
      Disclosures About
      Derivative Instruments and Hedging Activitiesan amendment to FAS
      133, Accounting for
      Derivative Instruments and Hedging Activities,issued March 2008,
      requires enhanced disclosures about an entity’s derivative and hedging
      activity.The
      standard requires that the objectives for using derivative instruments be
      disclosed in terms of underlying risk so that the reader understands the
      purpose of derivative use in terms of the risks that the entity is
      intending to manage.  The standard also requires disclosure of
      the location in the financial statements of derivative balances as well as
      the location of gains and losses incurred during the reporting
      period.  The standard will be applicable for fiscal years or
      interim periods beginning on or after November 15, 2008, with early
      adoption encouraged. The company is currently assessing the impact of this
      statement.
 
 ·
              FAS 160,
      Accounting and Reporting
      of Noncontrolling Interests in Consolidated Financial Statements,issued December 2007, will change the accounting and reporting for
      minority interests, requiring such amounts to be classified as a component
      of equity, and will also change the accounting for transactions with
      minority-interest holders. The standard will be applicable for fiscal
      years beginning on or after December 15, 2008 on a prospective
      basis.  Early adoption is prohibited and business combinations
      with acquisition dates prior to the effective date will not be adjusted
      upon application.  We do not expect this pronouncement to have a
      material impact on our financial
statements.
 
 ·
              FAS 141(R)
      Business
      Combinations - a replacement of FAS No. 141, issued December 2007,
      requires companies to record acquisitions at fair value.  FAS
      141(R) changes the definition of a business and a business combination and
      is generally expected to increase the number of transactions that will
      need to be accounted for at fair value.  The standard will be
      applicable for fiscal years beginning on or after December 15, 2008 and
      generally on a prospective basis.  Early adoption is prohibited
      and business combinations with acquisition dates prior to the effective
      date will not be adjusted upon application.  We do not expect
      this pronouncement to have a material impact 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.
  59
 Table of Contents
 
 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.
                The
      resolution of pending retail rate case proceedings and the resulting rate
      structures.
 
 2.
                Demand
      conditions in our retail service areas, including economic conditions,
      weather conditions, rate structures, demographic patterns, competing
      energy alternatives and the status of retail
  competition.
 
 3.
                Supply and
      demand conditions in wholesale energy markets, including volatility in
      market prices and illiquidity in markets, are affected by a variety of
      factors, which 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.
 
 4.
                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.
 
 5.
                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.
 
 6.
                The
      creditworthiness of the entities with which we transact business or have
      transacted business.
 
 7.
                Changes in
      accounting principles or the application of such principles to our
      businesses.
 
 8.
                Changes in
      the depreciable lives of our
assets.
 
 9.
                Unanticipated
      changes in future liabilities relating to employee benefit plans due to
      changes in market values of retirement plan assets and health care
      costs.
 
 10.
                The outcome
      of any ongoing or future
litigation.
 
  ITEM3. –
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
 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, 2007, 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 our Annual Report on Form 10-K for
the year ended December 31, 2007.  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 and the fuel and power procurement activities at TEP, UNS Gas and UNS
Electric.  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
  60
 Table of Contents
  operations, and the
generation operations departments of UniSource Energy.  To limit TEP,
UNS Gas and UNS Electric’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, UNS Gas and UNS Electric’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.
 
 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 physical position in the third quarter and must have
owned generation backing up all physical 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.
 
 TEP’s risk
management policies also allow for financial purchases and sales of energy
subject to specified risk parameters established and monitored by the Risk
Management Committee.  These include financial trades in a futures
account on an exchange, with the intent of optimizing market
opportunities.
 
 The majority of
TEP’s forward contracts are considered to be “normal purchases and sales” of
electric energy and are therefore not accounted for as 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 power sales and purchases, classified
as cash flow hedges, to fair value in Other Comprehensive Income, TEP recorded
the following net unrealized losses:
 
 Three
      Months Ended March 31,
              2008
              2007-Millions of
      Dollars-Net
      Unrealized (Loss)
              $(2)
              $(1)
 
 TEP also reported
the following net unrealized losses on forward power sales and
purchases:
 
 Three
      Months Ended March 31,
              2008
              2007-Millions of
      Dollars-Net
      Unrealized (Loss)
              $
      (3)
              $(1)
 
 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
  61
 Table of Contents
  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 three months of 2008, the average market price of natural gas was
$7.30 per MMBtu, or 15% higher than the same period in 2007.  The
table below summarizes TEP’s gas generation output and purchased power for the
first three months of 2008 and 2007.
 
 Three
      Months Ended March 31,
              2008
              2007
              2008
              2007-MWhs-
              % of Total
      ResourcesGas-Fired
      Generation
              200,000
              180,000
              6%
              6%Purchased
      Power
              430,000
              325,000
              14%
              11%
 
 To
adjust the value of its derivative gas swap contracts, classified as cash flow
hedges, to fair value in Other Comprehensive Income, TEP recorded the following
net unrealized gains:
 
 Three
      Months Ended March 31,
              2008
              2007-Millions of
      Dollars-Net
      Unrealized Gain
              $11
              $4
 
 The chart below
displays the valuation methodologies and maturities of TEP’s power and gas
derivative contracts.
 
 Unrealized
      Gain (Loss) of TEP’s
                Hedging
      and Trading Activities- Millions of
      Dollars -Source of
      Fair Value At March 31, 2008
              Maturity
                0 – 6
      months
              Maturity
                6 – 12
      months
              Maturity
                over 1
      yr.
              Total
                Unrealized
                Gain
      (Loss)Prices
      actively quoted
              $
      7
              $
      (1)
              $
      2
              $
      8Prices based
      on models and other valuation methods
              (5)
              -
              (1)
              (6)Total
              $
      2
              $
      (1)
              $
      1
              $
      2
 
 Sensitivity Analysis of
Derivatives
 
 TEP uses
sensitivity analysis to measure the impact of an unfavorable change in market
prices on the fair value of its derivative forward
contracts.  Unrealized gains and losses related to TEP’s derivative
contracts that are not cash flow hedges are reported on the income
statement.  Unrealized gains and losses related to derivative
contracts that are cash flow hedges are reported in Other Comprehensive Income;
the unrealized gains and losses are reversed as contracts settle and realized
gains or losses are recorded. The chart below summarizes the change in
unrealized gains or losses if market prices increase or decrease by 10%, as of
March 31, 2008.
 
 - Millions of
      Dollars -Change in
      Market Price As of March 31, 2008
              10%
      Increase
              10%
      DecreaseNon-Cash
      Flow HedgesForward
      power sales and purchase contracts
              $ 
      3
              $ 
      (3)Gas
      swap agreements
              3
              (3)Cash
      Flow HedgesForward
      power sales and purchase contracts
              $  -
              $  -Gas
      swap agreements
              6
              (6)
 
 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 our 2007 Annual Report on Form 10-K.
  62
 Table of Contents
 
 UNS
Gas
 
 UNS Gas is subject
to commodity price risk, primarily from the changes in the price of natural gas
purchased for its 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 or entering into financial gas
swaps 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.
 
 To
adjust the value of its gas swap agreements, classified as cash flow hedges, to
fair value in Other Comprehensive Income, UNS Gas recorded unrealized gains for
the three months ended March 31, 2008 of $2 millions.  In the three
months ended March 31, 2007, UNS Gas had no unrealized gains or losses recorded
in OCI.
 
 For UNS Gas’
forward gas purchase contracts, a 10% decrease in market prices would result in
a decrease in unrealized net gains of $2 million reported in OCI, while a 10%
increase in market prices would result in an increase in unrealized net gains
reported of $2 million reported in OCI.
 
 UNS
Electric
 
 UNS Electric is not
exposed to commodity price risk for its current purchase of electricity as it
has a fixed price full-requirements supply agreement with PWMT and a PPFAC
mechanism which fully recovers the costs incurred under such contract on a
timely basis.  This supply agreement with PWMT expires in May 2008 and
UNS Electric is in the process of replacing this energy resource.
 
 During 2006 and
2007, UNS Electric entered into various power supply agreements for periods of
one to five years beginning in June 2008.  Certain of these contracts
are at a fixed price per MW and others are indexed to natural gas
prices.  UNS Electric estimates its future minimum payments under
these contracts to be $64 million in 2008, $72 million in 2009, $39 million in
2010, $15 million in 2011, $9 million in 2012, and $9 million thereafter based
on natural gas prices at March 31, 2008.
 
 Because a portion
of the costs under these contracts will vary from period to period based on the
market price of gas, the PPFAC, as currently structured, may not provide
recovery of the costs incurred under these new contracts on a timely
basis.
 
 For the three
months ended March 31, 2008 and 2007, UNS Electric recorded unrealized gains of
$12 million and $1 million, respectively, to regulatory liabilities, to adjust
the fair value of its forward power purchase derivative contracts.
 
 For UNS Electric’s
forward power purchase contracts, a 10% decrease in market prices would result
in a decrease in unrealized net gains reported as a regulatory liability of $21
million, while a 10% increase in market prices would result in an increase in
unrealized net gains reported as a regulatory liability of $21
million.
 
 In
2007, UNS Electric began hedging a portion of its natural gas exposure from
gas-indexed purchase power agreements that begin in June 2008 with fixed price
contracts.  In addition, UNS Electric began hedging a portion of its
anticipated natural gas exposure from plant fuel for the period June 2008 and
beyond.  UNS Electric currently has approximately 32% of this
aggregate summer exposure hedged for the summer of 2008.  UNS Electric
will obtain its remaining gas and purchased power needs through a combination of
additional forward purchases and purchases in the short-term and spot
markets.
 
 For the three
months ended March 31, 2008, UNS Electric recorded unrealized gains of $4
million, to regulatory assets, to adjust the fair value of its gas swap
agreements.  UNS Electric had no gas swap agreements in the three
months ended March 31, 2008.
 
 For UNS Electric’s
forward gas purchase contracts, a 10% decrease in market prices would result in
a decrease in unrealized net gains reported as a regulatory liability of $3
million, while a 10% increase in market prices would result in an increase in
unrealized net gains reported as a regulatory liability of $3
million.
  63
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 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
standard agreements which allow for the netting of current period exposures to
and from a single counterparty.  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.  A positive number means that we are exposed to the
creditworthiness of our counterparties.  If exposure exceeds credit
limits or contractual collateral thresholds, we may request that a counterparty
provide credit enhancement in the form of cash collateral or a letter of
credit.  Conversely, a negative exposure means that a counterparty is
exposed to the creditworthiness of TEP, UNS Gas or UNS Electric.  If
such exposure exceeds credit limits or collateral thresholds, we may be required
to post collateral in the form of cash or other credit
enhancements.
 
 As
of March 31, 2008, TEP’s total credit exposure related to its wholesale
marketing and gas hedging activities was approximately $23
million.  Approximately $5 million of TEP’s exposure is to
non-investment grade companies.  TEP had two counterparties with an
exposure of greater than 10% of its total credit exposure, totaling
approximately $7 million.
 
 TEP maintains a
margin account with a broker to support certain risk management and trading
activities.  At March 31, 2008, TEP had approximately $1 million in
that margin account.  At March 31, 2008, TEP had $5 million
in  credit enhancements posted with counterparties, and did not hold
any collateral from its counterparties.
 
 UNS Gas is subject
to credit risk from non-performance by its supply and hedging counterparties to
the extent that these contracts have a mark-to-market value in favor of UNS
Gas.  As of March 31, 2008, UNS Gas had purchased under fixed price
contracts approximately 38% of the expected monthly consumption for the
2008/2009 winter season (November through March) and approximately 22% of its
expected consumption for the 2009/2010 winter season.  At March 31,
2008, UNS Gas had approximately $9 million in mark-to-market credit exposure
under its supply and hedging contracts.As of March 31,
2008, UNS Gas had no outstanding credit enhancements posted with
counterparties.
 
 UNS Electric has
begun to enter into energy purchase agreements to replace the full requirements
contract it has with PWMT that expires May 31, 2008, as well as gas hedging
contracts to hedge the risk in its gas-indexed power purchase
agreements.  To the extent that such contracts have a positive
mark-to-market value, UNS Electric would be exposed to credit risk under those
contracts.  At March 31, 2008, UNS Electric had approximately $27
million in credit exposure under such contracts.  All of UNS
Electric’s credit exposure is to investment grade counterparties.  One
of UNS Electric’s counterparties comprised 62% of its total credit
exposure.  As of March 31, 2008, UNS Electric had not posted any
credit enhancement with its counterparties and had not collected any collateral
margin from its counterparties.
 
 
 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, 2008.  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 are also designed to ensure that
information required to be disclosed by UniSource Energy and TEP in the reports
that they file or submit under the Exchange Act is accumulated and communicated
to management, including the principal executive and principal financial
officers, or person performing similar functions, as appropriate to allow timely
decisions regarding required disclosure. 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 2008 that has materially affected, or is reasonably
likely to materially affect, UniSource Energy or TEP’s internal control over
financial reporting.
 
 64
 Table of Contents
  PARTII – OTHER INFORMATION
 
 ITEM1. – LEGAL PROCEEDINGS
 
 There are no
pending material legal proceedings to which the Company is a party, other than
routine litigation incidental to the business of the Company.  We discuss other legal proceedings
inNote 7
ofNotes to
Consolidated Financial Statements, Commitments and
Contingencies.
 
 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 our 2007 Annual Report on Form
10-K.
 
 ITEM2. – UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF
PROCEEDS
 
 Issuer Purchases of
Equity Securities – None.
 
 ITEM4. – SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS
 
 UniSource Energy
conducted its annual meeting of shareholders on May 2, 2008.  At that
meeting, shareholders of UniSource Energy elected members of the Board of
Directors and ratified the selection of UniSource Energy’s independent auditors
for 2008.  The vote totals for each proposal are summarized
below.
 
 Proposal
      1: Election of Directors
              Votes
      For
              Votes
      WithheldLawrence J.
      Aldrich
              30,301,585
              196,802Barbara M.
      Baumann
              30,303,476
              194,911Larry W.
      Bickle
              30,290,167
              208,220Elizabeth T.
      Bilby
              30,303,794
              194,593Harold W.
      Burlingame
              30,300,062
              198,325John L.
      Carter
              30,297,661
              200,726Robert A.
      Elliott
              30,300,043
              198,344Daniel W.L.
      Fessler
              30,299,083
              199,304Kenneth
      Handy
              30,300,937
              197,450Warren Y.
      Jobe
              30,300,465
              197,922Ramiro G.
      Peru
              30,297,287
              201,100James S.
      Pignatelli
              30,208,590
              289,797Gregory A.
      Pivirotto
              30,300,680
              197,707Joaquin
      Ruiz
              30,297,038
              201,349Votes
      For
              Votes
      Against
              AbstainedProposal
      2: Ratification of Selection of Independent Auditor
              30,254,833
              186,926
              56,925
 65
 Table of Contents
  ITEM5. – OTHER INFORMATION
 
 NON-GAAP MEASURES
 
 Adjusted
EBITDA
 
 Adjusted EBITDA
represents EBITDA excluding the discontinued operations.  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 - Operating Activities.
 
 Adjusted
EBITDA and Net Cash Flows - Operating Activities
 
 UniSource
      EnergyThree
      Months Ended
                March
      31,2008
              2007- Millions of
      Dollars -Adjusted
      EBITDA (non-GAAP)(1)
              $  
       83
              $   
      96Net Cash
      Flows - Operating Activities (GAAP)
              $   
      55
              $   
      65Net Cash
      Flows - Investing Activities (GAAP)
              $ 
      (79)
              $ 
      (41)Net Cash
      Flows - Financing Activities (GAAP)
              $    29
              $ 
      (33)
 
 
 TEPThree
      Months Ended
                March
      31,2008
              2007- Millions of
      Dollars -Adjusted
      EBITDA (non-GAAP)(1)
              $   
      62
              $    77Net
      Cash Flows - Operating Activities (GAAP)
              $   
      55
              $   
      50Net
      Cash Flows - Investing Activities (GAAP)
              $  (63)
              $ 
      (26)Net
      Cash Flows - Financing Activities (GAAP)
              $   
      18
              $ 
      (10)
 
 Reconciliation
of Adjusted EBITDA to Cash Flows from Operations
 
 UniSource
      EnergyThree
      Months Ended
                March
      31,2008
              2007- Millions of
      Dollars -Adjusted EBITDA(non-GAAP)(1)
              $  
      83
              $  
      96Amounts from
      the Income Statements:Less: Income
      Taxes
              -
              4Less: Total
      Interest Expense
              31
              35Changes in
      Assets and Liabilities and Other Non-Cash Items
              3
              8Net Cash Flows - Operating
      Activities(GAAP)
              55
              65Net Cash Flows - Investing
      Activities(GAAP)
              (79)
              (41)Net Cash Flows - Financing
      Activities(GAAP)
              29
              (33)Net Decrease in Cash and Cash
      Equivalents(GAAP)
              $   
      5
              $   
      (9)
  66
 Table of Contents
  TEPThree
      Months Ended
                March
      31,2008
              2007- Millions of
      Dollars -Adjusted EBITDA(non-GAAP)(1)
              $  
      62
              $   
      77Amounts from
      the Income Statements:Less:  Income
      Taxes
              (4)
              1Less:  Total
      Interest Expense
              26
              29Changes in
      Assets and Liabilities and Other Non-Cash Items
              15
              3Net Cash Flows - Operating
      Activities(GAAP)
              55
              50Net Cash Flows - Investing
      Activities(GAAP)
              (63)
              (26)Net Cash Flows - Financing
      Activities(GAAP)
              18
              (10)Net
      Increase (Decrease) in Cash and Cash Equivalents(GAAP)
              $  
      10
              $ 
      14
  (1)
Adjusted EBITDA was calculated as follows:
 
 UniSource
      EnergyThree
      Months Ended
                March
      31,2008
              2007- Millions of
      Dollars -Net (Loss) Income(GAAP)
              $   
      (3)
              $   
      5Amounts from
      the Income Statements:Plus:  Income
      Taxes
              -
              4Total
      Interest Expense
              31
              35Depreciation and
      Amortization
              36
              35Amortization
      of Transition Recovery Asset
              17
              15Depreciation
      included in Fuel and Other O&MExpense
      (see Note 13 of Notes to ConsolidatedFinancial
      Statements)
              2
              2Adjusted EBITDA(non-GAAP)
              $  
      83
              $  
      96
 
 
 TEPThree
      Months Ended
                March
      31,2008
              2007- Millions of
      Dollars -Net (Loss) Income(GAAP)
              $   
      (9)
              $    
      1Amounts from
      the Income Statements:Plus:  Income
      Taxes
              (4)
              1Total
      Interest Expense
              26
              29Depreciation
      and Amortization
              31
              29Amortization
      of Transition Recovery Asset
              17
              15Depreciation
      included in Fuel and Other O&MExpense
      (see Note 13 of Notes to ConsolidatedFinancial
      Statements)
              1
              2Adjusted EBITDA(non-GAAP)
              $  
      62
              $  
      77
 
 
 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.  Investment in lease debt
is subtracted 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
  67
 Table of Contents
  similarly titled
measures used by other companies.  Net Debt is not a measurement
presented in accordance with GAAP and is not intended to represent debt as
defined by GAAP.  Net Debt should not be considered to be an
alternative to debt or any other items calculated in accordance with
GAAP.
 
 As
      of
                March
      31, 2008
              As
      of
                December
      31, 2007- Millions of
      Dollars -Net Debt
      (non-GAAP)
              $ 
      1,354
              $ 
      1,306Total Debt
      and Capital Lease Obligations (GAAP)
              $ 
      1,447
              $ 
      1,411
 
 Reconciliation
of Total Debt and Capital Lease Obligations to Net Debt
 
 As
      of
                March
      31, 2008
              As
      of
                December
      31, 2007- Millions of
      Dollars -Total
      Debt (GAAP)
              $     
      912
              $     
      821Capital Lease
      Obligations
              514
              531Current
      Portion – Capital Lease Obligations
              21
              59Total Debt and Capital Lease
      Obligations(GAAP)
              1,447
              1,411Investment in
      Lease Debt
              (93)
              (105)Net Debt(non-GAAP)
              $ 
      1,354
              $ 
      1,306
 
 
 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 EndedMarch
      31, 2008
              March
      31, 2008UniSource
      Energy
              0.87
              1.60TEP
              0
      78
              1.62
 
 For the three
months ended March 31, 2008, UniSource Energy and TEP had a deficiency of $6
million and $4 million, respectively.
 
 ITEM6. – EXHIBITS
 
 See Exhibit
Index.
 
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 Table of Contents
 
 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
      12, 2008
                /s/
                Kevin P. LarsonKevin P.
      Larson
                  Senior Vice
      President and Principal
                  Financial
      OfficerTUCSON ELECTRIC POWER
      COMPANY
                  (Registrant)Date:  May
      12, 2008
                /s/
                Kevin P. LarsonKevin P.
      Larson
                  Senior Vice
      President and Principal
                  Financial
      Officer
 69
 Table of Contents
 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 ofthe Securities Exchange Act of 1934, as
amended.
 70
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Contents