Document


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 June 30, 2017
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 1-5924
TUCSON ELECTRIC POWER COMPANY
(Exact name of registrant as specified in its charter)
Arizona
(State or other jurisdiction of incorporation or organization)
 
86-0062700
(I.R.S. Employer Identification No.)

88 East Broadway Boulevard, Tucson, AZ 85701
(Address of principal executive offices)(Zip Code)
Registrant's telephone number, including area code: (520) 571-4000
(Former name, former address and former fiscal year, if changed since last report): N/A

Indicate by check mark whether the 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 o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
Large Accelerated Filer o Accelerated Filer o Non-Accelerated Filer x Smaller Reporting Company o Emerging Growth Company o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
All shares of outstanding common stock of Tucson Electric Power Company are held by its parent company, UNS Energy Corporation, which is an indirect, wholly-owned subsidiary of Fortis Inc. There were 32,139,434 shares of common stock, no par value, outstanding as of July 27, 2017.




Table of Contents
PART I
 
 
 
 
 
PART II
 
 

ii




DEFINITIONS
The abbreviations and acronyms used in the second quarter 2017 Form 10-Q are defined below:
2017 Rate Order
 
A rate order issued by the ACC resulting in a new rate structure for TEP, effective on February 27, 2017
ACC
 
Arizona Corporation Commission
APS
 
Arizona Public Service Company
BART
 
Best Available Retrofit Technology
BBtu
 
Billion British thermal units
Cooling Degrees Days
 
An index used to measure the impact of weather on energy usage calculated by subtracting 75 from the average of the high and low daily temperatures
DG
 
Distributed Generation
DSM
 
Demand Side Management
EE Standards
 
Energy Efficiency Standards
EPA
 
Environmental Protection Agency
FERC
 
Federal Energy Regulatory Commission
Fortis
 
Fortis Inc., a corporation incorporated under the Corporations Act of Newfoundland and Labrador, Canada, whose principal executive offices are located at Fortis Place, Suite 1100, 5 Springdale Street, St. John's, NL A1E 0E4
Four Corners
 
Four Corners Generating Station
GAAP
 
Generally Accepted Accounting Principles in the United States of America
GWh
 
Gigawatt-hour(s)
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
kWh
 
Kilowatt-hour(s)
LFCR
 
Lost Fixed Cost Recovery
LOC
 
Letter(s) of Credit
MW
 
Megawatt(s)
MWh
 
Megawatt-hour(s)
Navajo
 
Navajo Generating Station
NBV
 
Net Book Value
Phase 2
 
Second phase of TEP's rate case proceedings originally filed November 2015
PNM
 
Public Service Company of New Mexico
PPA
 
Power Purchase Agreement
PPFAC
 
Purchased Power and Fuel Adjustment Clause
Regional Haze Rules
 
Rules promulgated by the EPA to improve visibility at national parks and wilderness areas
RES
 
Renewable Energy Standard
Retail Rates
 
Rates designed to allow a regulated utility recovery of its costs of providing services and an opportunity to earn a reasonable return on its investment
San Juan
 
San Juan Generating Station
SES
 
Southwest Energy Solutions, Inc.
SJCC
 
San Juan Coal Company
Springerville
 
Springerville Generating Station
SRP
 
Salt River Project Agricultural Improvement and Power District
Sundt
 
H. Wilson Sundt Generating Station
TEP
 
Tucson Electric Power Company, the principal subsidiary of UNS Energy Corporation
Third-Party Owners
 
Wilmington Trust Company and William J. Wade, as Owner Trustee and Co-trustee under a separate trust agreement with each of Alterna Springerville LLC (Alterna) and LDVF1 TEP LLC (LDVF1) (Alterna and LDVF1, together with the Owner Trustees and Co-trustees, the Third-Party Owners)

iii




TSA
 
Transmission Service Agreement
UNS Electric
 
UNS Electric, Inc., an indirect wholly-owned subsidiary of UNS Energy Corporation
UNS Energy
 
UNS Energy Corporation, the parent company of TEP, whose principal executive offices are located at 88 East Broadway Boulevard, Tucson, Arizona 85701
UNS Energy Affiliates
 
Affiliated subsidiaries of UNS Energy Corporation including UniSource Energy Services, Inc., UNS Electric, Inc., UNS Gas, Inc., and Southwest Energy Solutions, Inc.
UNS Gas
 
UNS Gas, Inc., an indirect wholly-owned subsidiary of UNS Energy Corporation
VIE
 
Variable Interest Entity


iv


Table of Contents

FORWARD-LOOKING INFORMATION
This Quarterly Report on Form 10-Q contains forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. Tucson Electric Power Company (TEP or the Company) is 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 TEP in this Quarterly Report on Form 10-Q. Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events, future operational, economical, or financial 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, believes, estimates, expects, intends, may, plans, predicts, potential, projects, would, 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 TEP, are expressly qualified by these cautionary statements and any other cautionary statements which may accompany the forward-looking statements. In addition, TEP disclaims any obligation to update any forward-looking statements to reflect events or circumstances after the date of this report, except as may otherwise be required by the federal securities laws.
Forward-looking statements involve risks and uncertainties which could cause actual results or outcomes to differ materially from those expressed therein. We express our estimates, expectations, beliefs, and projections in good faith and believe them to have a reasonable basis. However, we make no assurances that management’s estimates, 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: Part I, Item 1A. Risk Factors of our 2016 Form 10-K; Part II, Item 1A. Risk Factors; Part I, Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations; and other parts of this report. These factors include: state and federal regulatory and legislative decisions and actions; changes in, and compliance with, environmental laws and regulation decisions and policies that could increase operating and capital costs, reduce generating facility output, or accelerate generating facility retirements; regional economic and market conditions which could affect customer growth and energy usage; changes in energy consumption by retail customers; weather variations affecting energy usage; the cost of debt and equity capital and access to capital markets and bank markets; the performance of the stock market and changing interest rate environment, which affect the value of our pension and other postretirement benefit plan assets and the related contribution requirements and expense; the potential inability to make additions to our existing high voltage transmission system; unexpected increases in operations and maintenance expense; resolution of pending litigation matters; changes in accounting standards; changes in our critical accounting policies and estimates; the ongoing impact of mandated energy efficiency and distributed generation (DG) initiatives; changes to long-term contracts; the cost of fuel and power supplies; the ability to obtain coal from our suppliers; cyber-attacks, data breaches, or other challenges to our information security, including our operations and technology systems; and the performance of TEP's generating facilities.


v


Table of Contents

PART I
ITEM 1. FINANCIAL STATEMENTS
TUCSON ELECTRIC POWER COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(Amounts in thousands)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2017
 
2016
 
2017
 
2016
Operating Revenues
 
 
 
 
 
 
 
Retail
$
280,537

 
$
256,450

 
$
480,043

 
$
460,403

Wholesale
43,836

 
34,084

 
86,374

 
48,497

Other
27,771

 
26,950

 
54,109

 
52,063

Total Operating Revenues
352,144

 
317,484

 
620,526

 
560,963

Operating Expenses
 
 
 
 
 
 
 
Fuel
59,744

 
68,236

 
126,472

 
130,914

Purchased Power
43,841

 
24,023

 
68,136

 
41,763

Transmission and Other PPFAC Recoverable Costs
7,983

 
5,312

 
16,882

 
10,490

Increase (Decrease) to Reflect PPFAC Recovery Treatment
(7,417
)
 
7,470

 
(15,607
)
 
14,265

Total Fuel and Purchased Power
104,151

 
105,041

 
195,883

 
197,432

Operations and Maintenance
84,490

 
86,580

 
166,631

 
171,579

Depreciation
38,208

 
35,913

 
76,365

 
71,545

Amortization
5,458

 
5,545

 
10,860

 
11,021

Taxes Other Than Income Taxes
12,980

 
12,700

 
26,780

 
25,730

Total Operating Expenses
245,287

 
245,779

 
476,519

 
477,307

Operating Income
106,857

 
71,705

 
144,007

 
83,656

Other Income (Deductions)
 
 
 
 
 
 
 
Interest Income
433

 
29

 
526

 
67

Other Income
1,872

 
1,260

 
10,892

 
2,653

Other Expense
(776
)
 
(463
)
 
(1,537
)
 
(886
)
Appreciation in Value of Investments
484

 
660

 
1,218

 
860

Total Other Income (Deductions)
2,013

 
1,486

 
11,099

 
2,694

Interest Expense
 
 
 
 
 
 
 
Long-Term Debt
15,494

 
15,486

 
30,930

 
30,977

Capital Leases
664

 
855

 
1,328

 
1,713

Other Interest Expense
208

 
135

 
423

 
258

Interest Capitalized
(590
)
 
(397
)
 
(1,120
)
 
(861
)
Total Interest Expense
15,776

 
16,079

 
31,561

 
32,087

Income Before Income Taxes
93,094

 
57,112

 
123,545

 
54,263

Income Tax Expense
32,159

 
16,576

 
41,851

 
14,429

Net Income
$
60,935

 
$
40,536

 
$
81,694

 
$
39,834

The accompanying notes are an integral part of these financial statements.


1



TUCSON ELECTRIC POWER COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(Amounts in thousands)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2017
 
2016
 
2017
 
2016
Comprehensive Income
 
 
 
 
 
 
 
Net Income
$
60,935

 
$
40,536

 
$
81,694

 
$
39,834

Other Comprehensive Income
 
 
 
 
 
 
 
Net Changes in Fair Value of Cash Flow Hedges:
 
 
 
 
 
 
 
Net of Income Tax Expense of $59 and $81
96

 
129

 
 
 
 
Net of Income Tax Expense of $133 and $87
 
 
 
 
215

 
138

Supplemental Executive Retirement Plan Adjustments:
 
 
 
 
 
 
 
Net of Income Tax Expense of $43 and $35
70

 
57

 
 
 
 
Net of Income Tax Expense of $86 and $70
 
 
 
 
140

 
113

Total Other Comprehensive Income, Net of Tax
166

 
186

 
355

 
251

Total Comprehensive Income
$
61,101

 
$
40,722

 
$
82,049

 
$
40,085

The accompanying notes are an integral part of these financial statements.


2



TUCSON ELECTRIC POWER COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(Amounts in thousands)
 
Six Months Ended June 30,
 
2017
 
2016
Cash Flows from Operating Activities
 
 
 
Net Income
$
81,694

 
$
39,834

Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities:
 
 
 
Depreciation Expense
76,365

 
71,545

Amortization Expense
10,860

 
11,021

Amortization of Debt Issuance Costs
1,178

 
1,451

Use of Renewable Energy Credits for Compliance
11,245

 
8,403

Deferred Income Taxes
41,855

 
14,428

Pension and Other Postretirement Benefits Expense
8,019

 
7,669

Pension and Other Postretirement Benefits Funding
(5,165
)
 
(5,694
)
Allowance for Equity Funds Used During Construction
(2,792
)
 
(2,203
)
FERC Transmission Refund Payable
(4,878
)
 
10,086

Changes in Current Assets and Current Liabilities:
 
 
 
Accounts Receivable
(44,596
)
 
(21,707
)
Materials, Supplies, and Fuel Inventory
(4,825
)
 
4,151

Regulatory Assets
(7,217
)
 
(8,579
)
Accounts Payable and Accrued Charges
26,848

 
11,985

Regulatory Liabilities
(10,299
)
 
13,588

Other, Net
(8,475
)
 
550

Net Cash Flows—Operating Activities
169,817

 
156,528

Cash Flows from Investing Activities
 
 
 
Capital Expenditures
(151,207
)
 
(135,344
)
Purchase Intangibles, Renewable Energy Credits
(27,330
)
 
(19,570
)
Contributions in Aid of Construction
2,917

 
(722
)
Other, Net
(975
)
 

Net Cash Flows—Investing Activities
(176,595
)
 
(155,636
)
Cash Flows from Financing Activities
 
 
 
Proceeds from Borrowings, Revolving Credit Facilities
15,000

 

Repayments of Borrowings, Revolving Credit Facilities
(15,000
)
 

Payments of Capital Lease Obligations
(14,463
)
 
(13,703
)
Other, Net
320

 
(4,028
)
Net Cash Flows—Financing Activities
(14,143
)
 
(17,731
)
Net Decrease in Cash and Cash Equivalents
(20,921
)
 
(16,839
)
Cash and Cash Equivalents, Beginning of Period
35,962

 
55,684

Cash and Cash Equivalents, End of Period
$
15,041

 
$
38,845

The accompanying notes are an integral part of these financial statements.

3



TUCSON ELECTRIC POWER COMPANY
CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)
(Amounts in thousands, except share data)
 
June 30, 2017
 
December 31, 2016
ASSETS
 
 
 
Utility Plant
 
 
 
Plant in Service
$
5,683,029

 
$
5,975,139

Utility Plant Under Capital Leases
167,413

 
167,413

Construction Work in Progress
152,401

 
129,955

Total Utility Plant
6,002,843

 
6,272,507

Accumulated Depreciation and Amortization
(2,164,791
)
 
(2,385,053
)
Accumulated Amortization of Capital Lease Assets
(107,998
)
 
(104,648
)
Total Utility Plant, Net
3,730,054

 
3,782,806

 
 
 
 
Investments and Other Property
46,277

 
45,020

 
 
 
 
Current Assets
 
 
 
Cash and Cash Equivalents
15,041

 
35,962

Accounts Receivable, Net
173,410

 
124,934

Fuel Inventory
29,686

 
25,887

Materials and Supplies
101,584

 
97,126

Regulatory Assets
66,846

 
56,340

Derivative Instruments
5,876

 
4,966

Other
15,977

 
13,793

Total Current Assets
408,420

 
359,008

Regulatory and Other Assets
 
 
 
Regulatory Assets
253,746

 
225,453

Derivative Instruments
403

 
330

Other
49,941

 
37,372

Total Regulatory and Other Assets
304,090

 
263,155

Total Assets
$
4,488,841

 
$
4,449,989

The accompanying notes are an integral part of these financial statements.

(Continued)

4



TUCSON ELECTRIC POWER COMPANY
CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)
(Amounts in thousands, except share data)
 
June 30, 2017
 
December 31, 2016
CAPITALIZATION AND OTHER LIABILITIES
 
 
 
Capitalization
 
 
 
Common Stock Equity:
 
 
 
Common Stock (No Par Value, 75,000,000 Shares Authorized, 32,139,434 Shares Outstanding as of June 30, 2017, and December 31, 2016)
$
1,296,539

 
$
1,296,539

Capital Stock Expense
(6,357
)
 
(6,357
)
Retained Earnings
355,102

 
273,408

Accumulated Other Comprehensive Loss
(4,200
)
 
(4,555
)
Total Common Stock Equity
1,641,084

 
1,559,035

Preferred Stock (No Par Value, 1,000,000 Shares Authorized, None Outstanding as of June 30, 2017, and December 31, 2016)

 

Capital Lease Obligations
28,164

 
39,267

Long-Term Debt, Net
1,453,747

 
1,453,072

Total Capitalization
3,122,995

 
3,051,374

Current Liabilities
 
 
 
Capital Lease Obligations
48,110

 
51,765

Accounts Payable
108,921

 
89,797

Accrued Taxes Other than Income Taxes
41,578

 
37,639

Accrued Employee Expenses
23,638

 
29,465

Accrued Interest
14,635

 
14,508

Regulatory Liabilities
65,887

 
76,069

Customer Deposits
24,965

 
25,778

Derivative Instruments
3,671

 
2,641

Other
15,209

 
17,837

Total Current Liabilities
346,614

 
345,499

Regulatory and Other Liabilities
 
 
 
Deferred Income Taxes, Net
575,038

 
529,148

Regulatory Liabilities
213,999

 
300,700

Pension and Other Postretirement Benefits
131,061

 
131,630

Derivative Instruments
5,576

 
2,629

Other
93,558

 
89,009

Total Regulatory and Other Liabilities
1,019,232

 
1,053,116

 
 
 
 
Commitments and Contingencies

 

 
 
 
 
Total Capitalization and Other Liabilities
$
4,488,841

 
$
4,449,989

The accompanying notes are an integral part of these financial statements.

(Concluded)


5



TUCSON ELECTRIC POWER COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER'S EQUITY (Unaudited)
(Amounts in thousands)
 
Common Stock
 
Capital Stock Expense
 
Retained Earnings
 
Accumulated Other Comprehensive Loss
 
Total Stockholder's Equity
Balances as of December 31, 2015
$
1,296,539

 
$
(6,357
)
 
$
189,317

 
$
(4,564
)
 
$
1,474,935

Net Income
 
 
 
 
39,834

 
 
 
39,834

Other Comprehensive Income, Net of Tax
 
 
 
 
 
 
251

 
251

Adoption of ASU, Cumulative Effect Adjustment
 
 
 
 
9,653

 
 
 
9,653

Balances as of June 30, 2016
$
1,296,539

 
$
(6,357
)
 
$
238,804

 
$
(4,313
)
 
$
1,524,673

 
Common Stock
 
Capital Stock Expense
 
Retained Earnings
 
Accumulated Other Comprehensive Loss
 
Total Stockholder's Equity
Balances as of December 31, 2016
$
1,296,539

 
$
(6,357
)
 
$
273,408

 
$
(4,555
)
 
$
1,559,035

Net Income
 
 
 
 
81,694

 
 
 
81,694

Other Comprehensive Income, Net of Tax
 
 
 
 
 
 
355

 
355

Balances as of June 30, 2017
$
1,296,539

 
$
(6,357
)
 
$
355,102

 
$
(4,200
)
 
$
1,641,084

The accompanying notes are an integral part of these financial statements.


6

Table of Contents
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



NOTE 1. NATURE OF OPERATIONS AND FINANCIAL STATEMENT PRESENTATION
TEP is a regulated utility that generates, transmits, and distributes electricity to approximately 422,000 retail customers in a 1,155 square mile area in southeastern Arizona. TEP also sells electricity to other utilities and power marketing entities, located primarily in the western United States. TEP is a wholly-owned subsidiary of UNS Energy Corporation (UNS Energy), a utility services holding company. UNS Energy is an indirect wholly-owned subsidiary of Fortis Inc. (Fortis).
BASIS OF PRESENTATION
TEP's condensed consolidated financial statements and disclosures are presented in accordance with Generally Accepted Accounting Principles (GAAP) in the United States of America, including specific accounting guidance for regulated operations and the Securities and Exchange Commission's (SEC) interim reporting requirements.
The condensed consolidated financial statements include the accounts of TEP and its subsidiaries. In the consolidation process, accounts of the parent and subsidiaries are combined, and intercompany balances and transactions are eliminated. TEP jointly owns several generation and transmission facilities with both affiliated and non-affiliated entities. TEP's proportionate share of jointly owned facilities is recorded in Utility Plant on the Condensed Consolidated Balance Sheets, and its proportionate share of the operating costs associated with these facilities is included in the income statement. These condensed consolidated financial statements exclude some information and footnotes required by GAAP and the SEC for annual financial statement reporting and should be read in conjunction with the consolidated financial statements and footnotes in TEP's 2016 Annual Report on Form 10-K.
The condensed consolidated financial statements are unaudited, but, in management's opinion, include all normal, recurring adjustments necessary for a fair presentation of the results for the interim periods presented. Because weather and other factors cause seasonal fluctuations in sales, TEP's quarterly operating results are not indicative of annual operating results.
Certain amounts from prior periods have been reclassified to conform to the current period presentation. TEP's Condensed Consolidated Statements of Cash Flows reflect a reclassification from Provision for Springerville Unit 1 - Third-Party Owners Unrealized Revenue to Changes in Current Assets and Current LiabilitiesAccounts Receivable of $12 million for the six months ended June 30, 2016.
Variable Interest Entities
TEP regularly reviews contracts to determine if it has a variable interest in an entity, if that entity is a Variable Interest Entity (VIE), and if it is the primary beneficiary of the VIE. The primary beneficiary is required to consolidate the VIE when the variable interest holder has: (i) the power to direct activities that most significantly impact the economic performance of the VIE; and (ii) the obligation to absorb losses or the right to receive benefits that could potentially be significant to the VIE.
TEP routinely enters into long-term Renewable Purchased Power Agreements (PPA) with various entities. Some of these entities are VIEs due to the long-term fixed price component in the agreements. These PPAs effectively transfer commodity price risk to TEP, the buyer of the power, creating a variable interest. TEP has determined it is not a primary beneficiary as it lacks the power to direct the activities that most significantly impact the economic performance of the VIEs. TEP reconsiders whether it is a primary beneficiary of the VIEs on a quarterly basis.
As of June 30, 2017, the carrying amount of assets and liabilities in the balance sheet that relates to variable interests under long-term PPAs is predominantly related to working capital accounts and generally represents the amounts owed by TEP for the deliveries associated with the current billing cycle. TEP's maximum exposure to loss is limited to the cost of replacing the power if the providers do not meet the production guarantee. However, the exposure to loss is mitigated as the Company would likely recover these costs through retail customer cost recovery mechanisms. See Note 2 for additional information related to cost recovery mechanisms.
RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
Effective January 1, 2016, TEP adopted accounting guidance that simplifies the accounting for share-based payment accounting. The guidance requires that excess tax benefits and tax deficiencies be recorded as an income tax benefit or expense on the income statement and eliminates the requirement that excess tax benefits be realized before companies can recognize them. On adoption, using the modified retrospective method of transition, TEP recorded a cumulative effect adjustment of $10 million to increase retained earnings and decrease deferred income taxes related to prior period unrecognized excess tax benefits. The impact on the income and the cash flow statements was not significant. TEP elected to recognize forfeitures when they occur.

7

Table of Contents
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)    



Effective January 1, 2017, TEP adopted accounting guidance that requires the Company to measure inventory at the lower of cost and net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. The adoption of this change in accounting principle did not have any impact on TEP as the Company recovers the cost of inventory through its rates.
UTILITY PLANT
Utility Plant includes the business property and equipment that supports electric service, consisting primarily of generation, transmission, and distribution facilities. Utility plant is reported at original cost. Original cost includes materials and labor, contractor services, construction overhead (when applicable), and an Allowance for Funds Used During Construction, less contributions in aid of construction.
Retirements
As of June 30, 2017, TEP recorded the early retirement of Unit 2 of the San Juan Generating Station (San Juan) and the coal handling facilities at H. Wilson Sundt Generating Station (Sundt) in accordance with the 2017 Rate Order. As a result of the 2017 Rate Order, the Condensed Consolidated Balance Sheets reflect a: (i) $224 million decrease in Plant in Service and Accumulated Depreciation and Amortization related to San Juan Unit 2; and (ii) $14 million decrease in Regulatory Assets and Accumulated Depreciation and Amortization related to the coal handling facilities at Sundt. See Note 2 for additional information related to the 2017 Rate Order.
Also in June 2017, the Navajo Nation approved a land lease extension which allows TEP and the co-owners of Navajo Generating Station (Navajo) to continue operations through December 2019 and begin decommissioning activities thereafter. TEP is currently recovering Navajo capital and operating costs in base rates using a useful life of 2030. As a result of the planned early retirement of Navajo, $38 million of the facility's net book value (NBV) and other related costs were reclassified from Utility Plant, Net to Regulatory Assets on the Condensed Consolidated Balance Sheets.
Depreciation
Depreciation is recorded for owned utility plant on a group method straight-line basis at depreciation rates based on the economic lives of the assets. The Arizona Corporation Commission (ACC) approves depreciation rates for all generation and distribution assets. Transmission assets are subject to the jurisdiction of the Federal Energy Regulatory Commission (FERC). In the 2017 Rate Order, the ACC approved the results of a new depreciation study for TEP. To reflect the impact of the revised depreciation study on the estimated cost of removal, TEP transferred $87 million from Regulatory Liabilities to Accumulated Depreciation and Amortization on the Condensed Consolidated Balance Sheets as of June 30, 2017. See Note 2 for additional information related to the net cost of removal balance in Regulatory Liabilities.

NOTE 2. REGULATORY MATTERS
The ACC and the FERC each regulate portions of utility accounting practices and rates of TEP. The ACC regulates rates charged to retail customers, the siting of generation and transmission facilities, the issuance of securities, transactions with affiliated parties, and other utility matters. The ACC also enacts other regulations and policies that can affect business decisions and accounting practices. The FERC regulates terms and prices of transmission services and wholesale electricity sales.
2017 RATE ORDER
In February 2017, the ACC issued a rate order for new rates that took effect February 27, 2017 (2017 Rate Order). Provisions of the 2017 Rate Order include, but are not limited to:
a non-fuel base rate increase of $81.5 million, which includes $15 million of operating costs related to the 50.5% undivided interest in Unit 1 of Springerville Generating Station (Springerville) purchased by TEP in September 2016;
a 7.04% return on original cost rate base, which includes a cost of equity component of 9.75% and a cost of debt component of 4.32%;
adoption of TEP's proposed depreciation and amortization rates, which include a reduction in the depreciable life for San Juan Unit 1; and
approval of a request to apply excess depreciation reserves against the unrecovered NBV of San Juan Unit 2 and the coal handling facilities at Sundt due to early retirement.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)    



The ACC deferred matters related to net metering and rate design for new DG customers to a second phase of TEP’s rate case (Phase 2), which is currently expected to be completed in the first quarter of 2018. TEP cannot predict the outcome of these proceedings.
COST RECOVERY MECHANISMS
TEP has received regulatory decisions that allow for more timely recovery of certain costs through the recovery mechanisms described below.
Purchased Power and Fuel Adjustment Clause
TEP's Purchased Power and Fuel Adjustment Clause (PPFAC) rate is adjusted annually each April 1st and goes into effect for the subsequent 12-month period unless modified by the ACC. The PPFAC rate includes: (i) a forward component which is calculated by taking the difference between forecasted fuel and purchased power costs and the amount of those costs established in rates designed to allow a regulated utility recovery of its costs of providing services and an opportunity to earn a reasonable return on its investment (Retail Rates); and (ii) a true-up component that reconciles the difference between actual costs and those recovered in the preceding 12-month period. The PPFAC bank balance was over-collected by $25 million as of June 30, 2017 and by $38 million as of December 31, 2016.
In February 2017, the ACC approved a PPFAC credit to begin returning the over-collected balance to customers. The table below presents TEP's PPFAC rates approved by the ACC:
Period
 
Cents per kWh
March 2017 through March 2018
 
(0.20
)
May 2016 through February 2017
 
0.15

April 2015 through April 2016
 
0.68

Renewable Energy Standard
The ACC’s Renewable Energy Standard (RES) requires Arizona regulated utilities to increase their use of renewable energy each year until it represents at least 15% of their total annual retail energy requirements by 2025, with DG accounting for 30% of the annual renewable energy requirement. Arizona utilities must file an annual RES implementation plan for review and approval by the ACC.
In March 2017, the ACC approved TEP's 2017 RES implementation plan of $54 million, which was partially offset by applying $2 million of previously recovered carryover funds. TEP has been approved to recover the remaining $52 million through the RES surcharge. The recovery funds the following: (i) the above market cost of renewable power purchases; (ii) previously awarded performance-based incentives for customer installed DG; and (iii) various other program costs. TEP suspended its rooftop solar program effective December 2016, but requested approval of a community solar program. The ACC is expected to consider this program in Phase 2 of TEP's rate case.
The percentage of retail kilowatt-hour (kWh) sales attributable to the RES in 2016 was 11%, which exceeded the overall 2016 RES renewable energy requirement of 6%. Compliance is determined through the ACC's review of TEP's annual RES implementation plan. As TEP no longer pays incentives to obtain DG renewable energy credits, which are used to demonstrate compliance with the DG requirement, the ACC approved a waiver of the 2016 and 2017 residential DG requirement.
Energy Efficiency Standards
TEP is required to implement cost-effective Demand Side Management (DSM) programs to comply with the ACC's Energy Efficiency Standards (EE Standards). The EE Standards provide regulated utilities a DSM surcharge to recover the costs to implement DSM programs from retail customers, as well as, an annual performance incentive. TEP records its annual DSM performance incentive for the prior calendar year in the first quarter of each year, with $2 million recorded in both 2017 and 2016. This performance incentive is included in Retail Revenues on the Condensed Consolidated Statements of Income.
In February 2016, the ACC approved TEP’s 2016 energy efficiency implementation plan which included a budget of approximately $22 million, which was partially offset by applying $8 million of previously recovered carryover funds. TEP has been approved to collect the remaining $14 million from retail customers through the DSM surcharge. Energy savings realized through the programs will count toward meeting the EE Standards and the associated lost revenue will be partially recovered through the Lost Fixed Cost Recovery (LFCR) mechanism.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)    



In June 2016, TEP notified the ACC that it would not file a 2017 implementation plan and instead continue the 2016 level of recovery through the end of 2017. TEP plans to reduce its costs and incentive levels for certain programs in order to minimize any potential under-collected DSM balance at the end of 2017. TEP expects to file its 2018 implementation plan by August 2017.
Lost Fixed Cost Recovery Mechanism
The LFCR mechanism provides for recovery of certain non-fuel costs that would go unrecovered due to reduced retail kWh sales as a result of implementing ACC-approved energy efficiency programs and customer installed DG. TEP records a regulatory asset and recognizes LFCR revenues when the amounts are verifiable regardless of when the lost retail kWh sales occur. TEP is required to make an annual filing with the ACC requesting recovery of the LFCR revenues recognized in the prior year. The recovery is subject to a year-over-year cap of 2% of TEP's applicable retail revenues, as approved in the 2017 Rate Order.
TEP recorded regulatory assets and recognized LFCR revenues of $5 million and $11 million in the three and six months ended June 30, 2017, respectively, and $4 million and $9 million in the three and six months ended June 30, 2016, respectively. LFCR revenues are included in Retail Revenues on the Condensed Consolidated Statements of Income.
REGULATORY ASSETS AND LIABILITIES
Regulatory assets and liabilities recorded in the balance sheet are summarized in the table below:
(dollars in millions)
Remaining Recovery Period
(years)
 
June 30, 2017
 
December 31, 2016
Regulatory Assets
 
 
 
 
 
Pension and Other Postretirement Benefits (Note 7)
Various
 
$
124

 
$
128

Final Mine Reclamation and Retiree Health Care Costs (1)
20
 
30

 
27

Navajo Costs (2)
13
 
38

 

Income Taxes Recoverable through Future Rates
Various
 
30

 
29

Lost Fixed Cost Recovery
1
 
29

 
23

Property Tax Deferrals
1
 
23

 
23

Springerville Unit 1 Leasehold Improvements (3)
6
 
15

 
17

Sundt Coal Handling Facilities (4)
N/A
 

 
14

Other Regulatory Assets
Various
 
32

 
20

Total Regulatory Assets
 
 
321

 
281

Less Current Portion
1
 
67

 
56

Total Non-Current Regulatory Assets
 
 
$
254

 
$
225

Regulatory Liabilities
 
 
 
 
 
Net Cost of Removal (5)
Various
 
$
187

 
$
270

Renewable Energy Standard
Various
 
38

 
32

Purchased Power and Fuel Adjustment Clause
1
 
25

 
38

Deferred Investment Tax Credits
Various
 
21

 
23

Other Regulatory Liabilities
Various
 
9

 
14

Total Regulatory Liabilities
 
 
280

 
377

Less Current Portion
1
 
66

 
76

Total Non-Current Regulatory Liabilities
 
 
$
214

 
$
301

(1) 
Includes costs associated with TEP’s jointly-owned facilities at San Juan, Four Corners Generating Station (Four Corners), and Navajo. TEP recognizes these costs at future value and is permitted to fully recover these costs through the PPFAC mechanism. The majority of final mine reclamation costs are expected to occur through 2037.
(2) 
As a result of the planned early retirement of Navajo, the NBV and other related costs were reclassified from Utility Plant, Net on the Condensed Consolidated Balance Sheets as of June 30, 2017. See Note 1 for additional information related to the early retirement of Navajo.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)    



(3) 
Represents investments TEP made to ensure that the facilities continued to provide safe, reliable service to TEP's customers. TEP received ACC authorization to recover leasehold improvement costs at Springerville Unit 1 over a 10-year amortization period.
(4) 
The ACC authorized TEP to apply excess depreciation reserves against the unrecovered NBV in the 2017 Rate Order.
(5) 
Net Cost of Removal represents an estimate of the future cost of retirement net of salvage value. These are amounts collected through revenue for transmission, distribution, generation plant, and general and intangible plant which are not yet expended. As a result of the 2017 Rate Order, $87 million was transferred from Net Cost of Removal to Accumulated Depreciation and Amortization to reflect the impact of the revised depreciation study on the estimated cost of removal.
Regulatory assets are either being collected or are expected to be collected through Retail Rates. With the exception of the Navajo Costs and Springerville Unit 1 Leasehold Improvements, TEP does not earn a return on regulatory assets. Regulatory liabilities represent items that TEP either expects to pay to customers through billing reductions in future periods or plans to use for the purpose for which they were collected from customers. With the exception of over-recovered PPFAC costs, TEP does not pay a return on regulatory liabilities.
FERC COMPLIANCE
In 2016, the FERC issued orders relating to certain late-filed transmission service agreements (TSAs), which resulted in TEP recording a liability and paying time-value refunds to the counterparties of these TSAs. In May 2017, the FERC informed TEP that the related investigation was closed. See Note 6 for additional information related to FERC compliance associated with these transmission contracts.

NOTE 3. ACCOUNTS RECEIVABLE
The following table presents the components of Accounts Receivable, Net on the Condensed Consolidated Balance Sheets:
(in millions)
June 30, 2017
 
December 31, 2016
Customer
$
92

 
$
74

Due from Affiliates (Note 4)
7

 
9

Unbilled
61

 
34

Other
18

 
13

Allowance for Doubtful Accounts
(5
)
 
(5
)
Accounts Receivable, Net
$
173

 
$
125


NOTE 4. RELATED PARTY TRANSACTIONS
TEP engages in various transactions with Fortis, UNS Energy, and its affiliated subsidiaries including UNS Electric, Inc. (UNS Electric), UNS Gas, Inc. (UNS Gas), and Southwest Energy Solutions, Inc. (SES) (collectively, UNS Energy Affiliates). These transactions include the sale and purchase of power and transmission services, common cost allocations, and the provision of corporate and other labor related services.
The following table presents the components of related party balances included in Accounts Receivable, Net and Accounts Payable on the Condensed Consolidated Balance Sheets:
(in millions)
June 30, 2017
 
December 31, 2016
Receivables from Related Parties
 
 
 
UNS Electric
$
5

 
$
7

UNS Gas
2

 
2

Total Due from Related Parties
$
7

 
$
9

 
 
 
 
Payables to Related Parties
 
 
 
SES
$
2

 
$
2

UNS Energy
1

 

Total Due to Related Parties
$
3

 
$
2


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)    



The following table presents the related party transactions included in the Condensed Consolidated Statements of Income:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(in millions)
2017
 
2016
 
2017
 
2016
Goods and Services Provided by TEP to Affiliates

 

 
 
 
 
Transmission Revenues, UNS Electric (1)
$
2

 
$
2

 
$
3

 
$
3

Control Area Services, UNS Electric (2)
1

 
1

 
1

 
1

Common Costs, UNS Energy Affiliates (3)
4

 
4

 
8

 
7

 
 
 
 
 
 
 
 
Goods and Services Provided by Affiliates to TEP
 
 
 
 
 
 
 
Supplemental Workforce, SES (4)
4

 
3

 
7

 
7

Corporate Services, UNS Energy (5)
1

 
2

 
3

 
4

Corporate Services, UNS Energy Affiliates (6)
1

 
2

 
2

 
2

(1) 
TEP and UNS Electric sell power and transmission services to each other. Wholesale power is sold at prevailing market prices while transmission services are sold at FERC approved rates through the applicable Open Access Transmission Tariff.
(2) 
TEP charges UNS Electric for Control Area Services under a FERC-approved Control Area Services Agreement.
(3) 
Common Costs (information systems, facilities, etc.) are allocated on a cost-causative basis and recorded as revenue by TEP. The method of allocation is deemed reasonable by management and is reviewed by the ACC as part of the rate case process.
(4) 
SES provides supplemental workforce and meter-reading services to TEP based on related party service agreements. The charges are based on cost of services performed and are deemed reasonable by management.
(5) 
Costs for Corporate Services at UNS Energy are allocated to its subsidiaries using the Massachusetts Formula, an industry accepted method of allocating common costs to affiliated entities. TEP's allocation is approximately 82% of UNS Energy's allocated costs. Corporate Services, UNS Energy includes legal, audit, and Fortis management fees. TEP's share of Fortis' management fees were $1 million and $2 million for the three and six months ended June 30, 2017, respectively, and $2 million and $3 million for the three and six months ended June 30, 2016, respectively.
(6) 
Costs for Corporate Services (e.g., finance, accounting, tax, legal, and information technology) and other labor services for UNS Energy Affiliates are directly assigned to the benefiting entity at a fully burdened cost when possible.
CONTRIBUTION FROM PARENT
UNS Energy made no equity contributions to TEP in the three and six months ended June 30, 2017 or 2016.
DIVIDENDS PAID TO PARENT
TEP did not declare or pay dividends to UNS Energy in the three and six months ended June 30, 2017 or 2016. On July 24, 2017, TEP declared a $35 million dividend to UNS Energy to be paid by July 28, 2017.

NOTE 5. DEBT, CREDIT FACILITY, AND CAPITAL LEASE OBLIGATIONS
There have been no significant changes to TEP's debt, credit facility, or capital lease obligations from those reported in its 2016 Annual Report on Form 10-K, except as noted below.
CREDIT FACILITY
As of June 30, 2017, there was $250 million available under the revolving credit commitments and Letter of Credit (LOC) facility. As of July 27, 2017, TEP had $230 million available under its revolving credit commitments and LOC facility.
COVENANT COMPLIANCE
As of June 30, 2017, TEP was in compliance with the terms of its credit and long-term debt agreements.


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)    



NOTE 6. COMMITMENTS AND CONTINGENCIES
COMMITMENTS
There have been no significant changes to TEP's long-term commitments from those reported in its 2016 Annual Report on Form 10-K.
CONTINGENCIES
Legal Matters
TEP is party to a variety of legal actions arising out of the normal course of business. Plaintiffs occasionally seek punitive or exemplary damages. TEP believes such normal and routine litigation will not have a material impact on its condensed consolidated financial results. TEP is also involved in other kinds of legal actions, some of which assert or may assert claims or seek to impose fines, penalties, and other costs in substantial amounts on TEP and are disclosed below.
Claims Related to Four Corners Generating Station
Endangered Species Act
On April 20, 2016, several environmental groups filed a lawsuit in the U.S. District Court for the District of Arizona against the Office of Surface Mining (OSM) and other federal agencies under the Endangered Species Act (ESA) alleging that the OSM’s reliance on the Biological Opinion and Incidental Take Statement prepared in connection with a federal environmental review were not in accordance with applicable law. The environmental review was undertaken as part of the U.S. Department of the Interior’s review process necessary to allow for the effectiveness of lease amendments and related rights-of-way renewals for Four Corners. This review process also required separate environmental impact evaluations under the National Environmental Policy Act (NEPA) and culminated in the issuance of a Record of Decision justifying the agency action extending the life of Four Corners and the adjacent Navajo Mine. In addition, the lawsuit alleges that these federal agencies violated both the ESA and the NEPA in providing the federal approvals necessary to extend operations at Four Corners and Navajo Mine past July 6, 2016. The lawsuit seeks various forms of relief, including a finding that the federal defendants violated the ESA and the NEPA by issuing the Record of Decision, setting aside and remanding the Biological Opinion and Record of Decision, and enjoining the federal defendants from authorizing any elements of the Four Corners and Navajo Mine pending compliance with NEPA. In July 2016, the defendants answered the complaint and Arizona Public Service Company (APS), the operator of Four Corners, filed a motion to intervene in this matter. APS’ motion was granted in August 2016. In September 2016, Navajo Transitional Energy Company, LLC (NTEC), the company that owns the Navajo Mine, filed a motion to intervene for the purpose of dismissing the lawsuit based on NTEC’s tribal sovereign immunity. Because the court has placed a stay on all litigation deadlines pending its decision regarding NTEC’s motion to dismiss, the schedule for briefing and the anticipated timeline for completion of this litigation will likely be extended. TEP cannot currently predict the outcome of this matter or the range of its potential impact.
Claims Related to San Juan Generating Station
WildEarth Guardians
In February 2013, WildEarth Guardians (WEG) filed a Petition for Review in the U.S. District Court for the District of Colorado against the OSM challenging federal administrative decisions issued at various times from 2007 through 2012. In its petition, WEG challenges several unrelated mining plan modification approvals, which were each separately approved by the OSM. Of the claims for relief in the WEG Petition, two concern San Juan Coal Company’s (SJCC) San Juan mine. WEG’s allegations concerning the San Juan mine arise from the OSM administrative actions in 2008. WEG alleges various NEPA violations against the OSM, including, but not limited to, the OSM’s alleged failure to provide requisite public notice and participation, alleged failure to analyze certain environmental impacts, and alleged reliance on outdated and insufficient documents. WEG’s petition seeks various forms of relief, including a finding that the federal defendants violated the NEPA by approving the mine plans, voiding, reversing, and remanding the various mining modification approvals, enjoining the federal defendants from re-issuing the mining plan approvals for the mines until compliance with the NEPA has been demonstrated, and enjoining operations at the affected mines. SJCC intervened in this matter. SJCC was granted its motion to sever its claims from the lawsuit and transfer venue to the U.S. District Court for the District of New Mexico, where this matter is now proceeding. On July 18, 2016, the federal defendants filed a motion asking that the matter be voluntarily remanded to the OSM so the OSM may prepare a new environmental impact statement (EIS) under the NEPA regarding the impacts of the San Juan Mine mining plan approval. In August 2016, the court issued an order granting the federal defendants’ motion for remand to conduct further environmental analysis and complete an EIS by August 31, 2019. The order provided that the OSM’s decision approving the mining plan will remain in effect during this process. The order further provides that if the EIS is not completed

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)    



by August 31, 2019, then an order vacating the approved mine plan will become immediately effective, absent further court order. TEP cannot currently predict the outcome of this matter or the range of its potential impact.
Mine Reclamation at Generating Facilities Not Operated by TEP
TEP pays ongoing reclamation mine costs related to coal mines that supply generation facilities in which TEP has an ownership interest but does not operate. TEP is also liable for a portion of final mine reclamation costs upon closure of the mines servicing Navajo, San Juan, and Four Corners. TEP’s share of reclamation costs at all three mines is expected to be $61 million upon expiration of the coal supply agreements, which expire between 2019 and 2031. The balance sheet reflected a total liability related to reclamation of $28 million as of June 30, 2017 and $26 million as of December 31, 2016.
Amounts recorded for final mine reclamation are subject to various assumptions, such as estimations of reclamation costs, the dates when final reclamation will occur, and the expected inflation rate. As these assumptions change, TEP will prospectively adjust the expense amounts for final reclamation over the remaining coal supply agreements’ terms. TEP does not believe that recognition of its final reclamation obligations will be material to TEP in any single year because recognition will occur over the remaining terms of its coal supply agreements.
TEP’s PPFAC allows the Company to pass through final mine reclamation costs, as a component of fuel costs, to retail customers. Therefore, TEP classifies these costs as a regulatory asset by increasing the regulatory asset and the reclamation liability over the remaining life of the coal supply agreements and recovers the regulatory asset through the PPFAC as final mine reclamation costs are paid to the coal suppliers.
FERC Compliance
In 2015 and 2016, TEP self-reported to the FERC Office of Enforcement (OE) that the Company had not timely filed certain FERC-jurisdictional agreements. TEP conducted comprehensive internal reviews of its compliance with the FERC filing requirements (Compliance Reviews) and made compliance filings with the FERC Office of Energy Market Regulation. This included the filing of several TSAs entered into between 2003 and 2015 that contained certain deviations from TEP’s standard service agreement form.
In 2016, the FERC issued orders related to the late-filed TSAs which directed TEP to issue time-value refunds to the counterparties to these TSAs (FERC Refund Orders). As a result of the FERC Refund Orders and ongoing discussions with the OE, TEP recorded a liability for the time-value refunds with a corresponding offset in revenues on its financial statements in 2016. For the six months ended June 30, 2016, Wholesale Revenues on the Condensed Consolidated Statements of Income reflected $13 million related to the time-value refunds. As of December 31, 2016, Current Liabilities—Other on the Condensed Consolidated Balance Sheets reflected $5 million related to the time-value refunds.
In June 2016, to preserve its rights, TEP petitioned the U.S. Court of Appeals for the District of Columbia Circuit to review the FERC Refund Orders. In January 2017, TEP and one of the TSA counterparties entered into a settlement agreement regarding the FERC Refund Orders. In accordance with the agreement, the counterparty paid TEP $8 million, which TEP recorded in Other Income on the Condensed Consolidated Statements of Income and dismissed the appeal with prejudice in January 2017.
In May 2017, the FERC informed TEP that: (i) no further enforcement actions were necessary regarding the late-filed TSAs; and (ii) the related investigation was closed. As management no longer believed a loss was probable, TEP reversed the $5 million remaining balance related to potential time-value refunds in Current Liabilities—Other on the Condensed Consolidated Balance Sheets, offsetting Wholesale Revenues on the Condensed Consolidated Statements of Income.
Performance Guarantees
TEP has joint participation agreements with participants at Navajo, San Juan, Four Corners, and with Luna Generating Station (Luna). The participants in each of the generation facilities, including TEP, have guaranteed certain performance obligations. Specifically, in the event of payment default, the non-defaulting participants have agreed to bear a proportionate share of expenses otherwise payable by the defaulting participant. In exchange, the non-defaulting participants are entitled to receive their proportionate share of the generation capacity of the defaulting participant. With the exception of Four Corners, there is no maximum potential amount of future payments TEP could be required to make under the guarantees. The maximum potential amount of future payments is $250 million at Four Corners. As of June 30, 2017, there have been no such payment defaults under any of the participation agreements. The Navajo participation agreement expires in 2019, San Juan in 2022, Four Corners in 2041, and Luna in 2046.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)    



Environmental Matters
TEP is subject to federal, state, and local environmental laws and regulations regarding air and water quality, renewable portfolio standards, emissions performance standards, climate change, coal combustion byproduct disposal, hazardous and solid waste disposal, protected species, and other environmental matters that have the potential to impact TEP's current and future operations. Environmental laws and regulations are subject to a range of interpretations, which may ultimately be resolved by the courts. Because these laws and regulations continue to evolve, TEP is unable to predict the impact of the changing laws and regulations on its operations and condensed consolidated financial results. TEP expects to recover the cost of environmental compliance from its ratepayers. TEP believes it is in material compliance with applicable environmental laws and regulations.

NOTE 7. EMPLOYEE BENEFIT PLANS
Net periodic benefit cost includes the following components:
 
Pension Benefits
 
Other Postretirement Benefits
 
Three Months Ended June 30,
(in millions)
2017
 
2016
 
2017
 
2016
Service Cost
$
3

 
$
3

 
$
1

 
$
1

Interest Cost
4

 
3

 
1

 
1

Expected Return on Plan Assets
(6
)
 
(6
)
 

 
(1
)
Amortization of Net Loss
2

 
2

 

 

Net Periodic Benefit Cost
$
3

 
$
2

 
$
2

 
$
1

 
Pension Benefits
 
Other Postretirement Benefits
 
Six Months Ended June 30,
(in millions)
2017
 
2016
 
2017
 
2016
Service Cost
$
6

 
$
6

 
$
2

 
$
2

Interest Cost
8

 
7

 
1

 
1

Expected Return on Plan Assets
(12
)
 
(12
)
 

 
(1
)
Amortization of Net Loss
4

 
4

 

 

Net Periodic Benefit Cost
$
6

 
$
5

 
$
3

 
$
2

CONTRIBUTIONS
TEP contributed $3 million during the six months ended June 30, 2017 to the pension plans and expects to contribute a total of $9 million in 2017.

NOTE 8. SUPPLEMENTAL CASH FLOW INFORMATION
NON-CASH TRANSACTIONS
Other significant non-cash investing and financing activities that affected recognized assets and liabilities but did not result in cash receipts or payments were as follows:
 
Six Months Ended June 30,
(in millions)
2017
 
2016
Net Cost of Removal (1)
$
82

 
$

Accrued Capital Expenditures
17

 
11

(1) 
Non-cash Net Cost of Removal represents an accrual for future cost of retirement net of salvage values that does not impact earnings. In the 2017 Rate Order, the ACC authorized a new depreciation study for TEP modifying its depreciation reserves and rates. See Note 2 for additional information.


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)    



NOTE 9. FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS
TEP categorizes financial instruments into the three-level hierarchy based on inputs used to determine the fair value. Level 1 inputs are unadjusted quoted prices for identical assets or liabilities in an active market. Level 2 inputs include quoted prices for similar assets or liabilities, quoted prices in non-active markets, and pricing models whose inputs are observable, directly or indirectly. Level 3 inputs are unobservable and supported by little or no market activity. Transfers between levels are recorded at the end of a reporting period. There were no transfers between levels in the periods presented.
FINANCIAL INSTRUMENTS MEASURED AT FAIR VALUE ON A RECURRING BASIS
The following tables present, by level within the fair value hierarchy, TEP’s assets and liabilities accounted for at fair value on a recurring basis. These assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
 
Level 1
 
Level 2
 
Level 3
 
Total
(in millions)
June 30, 2017
Assets
 
Cash Equivalents(1)
$
3

 
$

 
$

 
$
3

Restricted Cash(1)
8

 

 

 
8

Energy Derivative Contracts, Regulatory Recovery(2)

 
1

 
1

 
2

Energy Derivative Contracts, No Regulatory Recovery(2)

 

 
4

 
4

Total Assets
11

 
1

 
5

 
17

Liabilities
 
 
 
 
 
 
 
Energy Derivative Contracts, Regulatory Recovery(2)

 
(7
)
 
(1
)
 
(8
)
Interest Rate Swap(3)

 
(1
)
 

 
(1
)
Total Liabilities

 
(8
)
 
(1
)
 
(9
)
Total Assets (Liabilities), Net
$
11

 
$
(7
)
 
$
4

 
$
8

(in millions)
December 31, 2016
Assets
 
Cash Equivalents(1)
$
23

 
$

 
$

 
$
23

Restricted Cash(1)
7

 

 

 
7

Energy Derivative Contracts, Regulatory Recovery(2)

 
3

 

 
3

Energy Derivative Contracts, No Regulatory Recovery(2)

 

 
2

 
2

Total Assets
30

 
3

 
2

 
35

Liabilities
 
 
 
 
 
 
 
Energy Derivative Contracts, Regulatory Recovery(2)

 
(2
)
 
(1
)
 
(3
)
Interest Rate Swap(3)

 
(2
)
 

 
(2
)
Total Liabilities

 
(4
)
 
(1
)
 
(5
)
Total Assets (Liabilities), Net
$
30

 
$
(1
)
 
$
1

 
$
30

(1) 
Cash Equivalents and Restricted Cash represent amounts held in money market funds and certificates of deposit valued at cost, including interest, which approximates fair market value. Cash Equivalents are included in Cash and Cash Equivalents on the Condensed Consolidated Balance Sheets. Restricted cash is included in Investments and Other Property and in Current Assets—Other on the Condensed Consolidated Balance Sheets.
(2) 
Energy Contracts include gas swap agreements (Level 2), and forward purchased power and sales contracts (Level 3) entered into to reduce exposure to energy price risk. These contracts are included in Derivative Instruments on the Condensed Consolidated Balance Sheets. The valuation techniques are described below.
(3) 
The Interest Rate Swap is valued using an income valuation approach based on the 6-month London Interbank Offered Rate (LIBOR) and is included in Derivative Instruments on the Condensed Consolidated Balance Sheets.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)    



All energy derivative contracts are subject to legally enforceable master netting arrangements to mitigate credit risk. TEP presents derivatives on a gross basis in the balance sheet. The tables below present the potential offset of counterparty netting and cash collateral.
 
Gross Amount Recognized in the Balance Sheets
 
Gross Amount Not Offset in the Balance Sheets
 
Net Amount
 
 
Counterparty Netting of Energy Contracts
 
Cash Collateral Received/Posted
 
(in millions)
June 30, 2017
Derivative Assets
 
 
 
 
 
 
 
Energy Derivative Contracts
$
6

 
$
2

 
$

 
$
4

Derivative Liabilities
 
 
 
 
 
 
 
Energy Derivative Contracts
(8
)
 
(2
)
 

 
(6
)
Interest Rate Swap
(1
)
 

 

 
(1
)
(in millions)
December 31, 2016
Derivative Assets
 
 
 
 
 
 
 
Energy Derivative Contracts
$
5

 
$
2

 
$

 
$
3

Derivative Liabilities
 
 
 
 
 
 
 
Energy Derivative Contracts
(3
)
 
(2
)
 

 
(1
)
Interest Rate Swap
(2
)
 

 

 
(2
)
DERIVATIVE INSTRUMENTS
TEP enters into various derivative and non-derivative contracts to reduce exposure to energy price risk associated with its natural gas and purchased power requirements. The objectives for entering into such contracts include: (i) creating price stability; (ii) meeting load and reserve requirements; and (iii) reducing exposure to price volatility that may result from delayed recovery under the PPFAC mechanism.
The Company primarily applies the market approach for recurring fair value measurements. When TEP has observable inputs for substantially the full term of the asset or liability or uses quoted prices in an inactive market, it categorizes the instrument in Level 2. TEP categorizes derivatives in Level 3 when an aggregate pricing service or published prices that represent a consensus reporting of multiple brokers is used.
For both purchased power and natural gas prices, TEP obtains quotes from brokers, major market participants, exchanges, or industry publications and relies on its own price experience from active transactions in the market. The Company primarily uses one set of quotations each for purchased power and natural gas and then validates those prices using other sources. TEP believes that the market information provided is reflective of market conditions as of the time and date indicated.
Published prices for energy derivative contracts may not be available due to the nature of contract delivery terms such as non-standard time blocks and non-standard delivery points. In these cases, TEP applies adjustments based on historical price curve relationships, transmission costs, and line losses.
TEP also considers the impact of counterparty credit risk using current and historical default and recovery rates, as well as its own credit risk using credit default swap data.
The inputs and the Company's assessments of the significance of a particular input to the fair value measurements require judgment and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels. TEP reviews the assumptions underlying its price curves monthly.
Cash Flow Hedges
To mitigate the exposure to volatility in variable interest rates on debt, TEP has an interest rate swap agreement that expires January 2020. The after-tax unrealized gains and losses on cash flow hedge activities are reported in the statement of comprehensive income. The loss expected to be reclassified to earnings within the next twelve months is estimated to be $1 million.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)    



The realized losses from its cash flow hedges are shown in the following table:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(in millions)
2017
 
2016
 
2017
 
2016
Capital Lease Interest Expense
$

 
$

 
$

 
$
1

As of June 30, 2017, the total notional amount of the interest rate swap was $18 million.
Energy Derivative Contracts - Regulatory Recovery
TEP records unrealized gains and losses on energy purchase contracts that are recoverable through the PPFAC mechanism on the balance sheet as a regulatory asset or a regulatory liability rather than reporting the transaction in the income statement or in the statement of other comprehensive income, as shown in the following table:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(in millions)
2017
 
2016
 
2017
 
2016
Unrealized Net Gain (Loss) Recorded to Regulatory (Assets) Liabilities
$

 
$
12

 
$
(6
)
 
$
9

Energy Derivative Contracts - No Regulatory Recovery
TEP enters into certain contracts that qualify as derivatives, but do not meet the regulatory recovery criteria. The Company records unrealized gains and losses for these contracts in the income statement unless a normal purchase or normal sale election is made. For contracts that meet the trading definition, as defined in the PPFAC plan of administration, TEP must share 10% of any realized gains with retail customers through the PPFAC mechanism.
Derivative Volumes
As of June 30, 2017, TEP had energy contracts that will settle on various expiration dates through 2020. The volumes associated with the energy contracts were as follows:
 
June 30, 2017
 
December 31, 2016
Power Contracts GWh
4,322

 
2,610

Gas Contracts BBtu
28,950

 
12,355

Level 3 Fair Value Measurements
The following tables provide quantitative information regarding significant unobservable inputs in TEP’s Level 3 fair value measurements:
 
Valuation Approach
 
Fair Value of
 
 
 
Range of Unobservable Input
 
 
Assets
 
Liabilities
 
Unobservable Inputs
 
(in millions)
June 30, 2017
Forward Power Contracts
Market approach
 
$
5

 
$
(1
)
 
Market price per MWh
 
$
18.15

 
$
39.95

(in millions)
December 31, 2016
Forward Power Contracts
Market approach
 
$
2

 
$
(1
)
 
Market price per MWh
 
$
20.90

 
$
40.00

Changes in one or more of the unobservable inputs could have a significant impact on the fair value measurement depending on the magnitude of the change and the direction of the change for each input. The impact of changes to fair value, including changes from unobservable inputs, are subject to recovery or refund through the PPFAC mechanism and are reported as a regulatory asset or regulatory liability, or as a component of other comprehensive income, rather than in the income statement.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)    



The following table presents a reconciliation of changes in the fair value of net assets and liabilities classified as Level 3 in the fair value hierarchy, and the gains (losses) attributable to the change in unrealized gains (losses) relating to assets (liabilities) still held at the end of the period:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(in millions)
2017
 
2016
 
2017
 
2016
Beginning of Period
$
1

 
$
(3
)
 
$
1

 
$
(2
)
Gains (Losses) Recorded
 
 
 
 
 
 
 
Regulatory Assets or Liabilities, Derivative Instruments

 
3

 
2

 
2

Wholesale Revenues
4

 
3

 
4

 
3

Settlements
(1
)
 

 
(3
)
 

End of Period
$
4

 
$
3

 
$
4

 
$
3

 
 
 
 
 
 
 
 
Gains (Losses), Assets (Liabilities) still held
$
5

 
$
6

 
$
4

 
$
6

CREDIT RISK
The use of contractual arrangements to manage the risks associated with changes in energy commodity prices creates credit risk exposure resulting from the possibility of non-performance by counterparties pursuant to the terms of their contractual obligations. TEP enters into contracts for the physical delivery of power and natural gas which contain remedies in the event of non-performance by the supply counterparties. In addition, volatile energy prices can create significant credit exposure from energy market receivables and subsequent measurement at fair value.
TEP has contractual agreements for energy procurement and hedging activities that contain certain provisions requiring TEP and its counterparties to post collateral under certain circumstances. These circumstances include: (i) exposures in excess of unsecured credit limits; (ii) credit rating downgrades; or (iii) a failure to meet certain financial ratios. In the event that such credit events were to occur, the Company, or its counterparties, would have to provide certain credit enhancements in the form of cash, a LOC, or other acceptable security to collateralize exposure beyond the allowed amounts.
TEP considers the effect of counterparty credit risk in determining the fair value of derivative instruments that are in a net asset position, after incorporating collateral posted by counterparties, and then allocates the credit risk adjustment to individual contracts. TEP also considers the impact of its credit risk on instruments that are in a net liability position, after considering the collateral posted, and then allocates the credit risk adjustment to the individual contracts.
Material adverse changes could trigger credit risk-related contingent features. The value of all derivative instruments in net liability positions under contracts with credit risk-related contingent features, including contracts under the normal purchase normal sale exception, was $27 million as of June 30, 2017, compared with $8 million as of December 31, 2016. As of June 30, 2017, TEP had no LOCs as credit enhancements with its counterparties. If the credit risk contingent features were triggered on June 30, 2017, TEP would have been required to post an additional $27 million of collateral of which $22 million relates to outstanding net payable balances for settled positions.
FINANCIAL INSTRUMENTS NOT CARRIED AT FAIR VALUE
The fair value of a financial instrument is the market price to sell an asset or transfer a liability at the measurement date. TEP uses the following methods and assumptions for estimating the fair value of financial instruments:
Borrowings under revolving credit facilities approximate fair value due to the short-term nature of these financial instruments. These items have been excluded from the table below.
For long-term debt, TEP uses quoted market prices, when available, or calculates the present value of the remaining cash flows at the balance sheet date. When calculating present value, the Company uses current market rates for bonds with similar characteristics such as credit rating and time-to-maturity. TEP considers the principal amounts of variable rate debt outstanding to be reasonable estimates of the fair value. The Company also incorporates the impact of its own credit risk using a credit default swap rate.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)    



The use of different estimation methods and/or market assumptions may yield different estimated fair value amounts. The following table includes the face value and estimated fair value of TEP's long-term debt:
 
Fair Value Hierarchy
 
Face Value
 
Fair Value
(in millions)
 
June 30, 2017
 
December 31, 2016
 
June 30, 2017
 
December 31, 2016
Liabilities
 
 
 
 
 
 
 
 
 
Long-Term Debt, including Current Maturities
Level 2
 
$
1,466

 
$
1,466

 
$
1,522

 
$
1,472


NOTE 10. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
TEP considers the applicability and impact of all accounting standard updates issued by the Financial Accounting Standards Board (FASB). The following updates have been issued, but have not yet been adopted by TEP. Updates not listed below were assessed and either determined to not be applicable or are expected to have a minimal impact on TEP's condensed consolidated financial position, results of operations, or disclosures.
REVENUE FROM CONTRACTS WITH CUSTOMERS
In May 2014, the FASB issued an accounting standard update that will eliminate the transaction and industry-specific revenue recognition guidance under current GAAP and replace it with a principles-based approach for determining revenue recognition. In July 2015, the FASB voted to defer the effective date of the revenue recognition standard by one year, and TEP is required to adopt the new guidance for annual and interim periods beginning January 1, 2018. The Company has elected not to early adopt this standard.
The revenue standard requires entities to apply the guidance retrospectively or under the modified retrospective approach by recognizing the cumulative effect of initially applying the guidance as an adjustment to the opening balance of retained earnings supplemented by additional disclosures. TEP expects to use the modified retrospective approach.
The sale of energy to retail and wholesale customers based on regulator-approved tariff rates represents TEP’s primary source of revenue and is considered in scope of this standard. TEP has assessed the retail and wholesale tariff-based revenues and does not expect that the adoption of this standard will change TEP’s accounting policy for recognizing retail and wholesale tariff-based revenues and, therefore, will not have an impact on earnings.
TEP continues to assess whether this standard will have an impact on its remaining revenue streams. The Company has not disclosed the expected impact of the adoption of this standard on its consolidated financial statements as it is not expected to be material. However, certain industry specific interpretative issues remain outstanding and the conclusions reached, if different than currently anticipated, could change the Company's expected method of adoption and have a material impact on its consolidated financial statements.
The adoption of this standard will impact the Company’s revenue disclosures as revenue from contracts with customers is required to be reported separately from alternative revenue, which is outside the scope of this standard. TEP is in the process of drafting these required disclosures.
As part of its effort to adopt the new revenue recognition standard, TEP is monitoring its adoption process under its existing Internal Control over Financial Reporting (ICFR), including accounting processes and the gathering and evaluation of information used in assessing the required disclosures. As the implementation process continues, TEP will assess any necessary changes to its ICFR.
LEASES
In February 2016, the FASB issued an accounting standard update that will require the recognition of leased assets and liabilities by lessees for those leases classified as operating leases under current GAAP. The standard is effective for periods beginning January 1, 2019, and is to be applied using a modified retrospective approach with practical expedient options. Early adoption is permitted. TEP is evaluating the impact of this update to its financial statements and disclosures.
RESTRICTED CASH
In November 2016, the FASB issued an accounting standard update that will require entities to show the changes in the total of cash, cash equivalents, and restricted cash or restricted cash equivalents in the cash flow statement. As a result, entities will no longer present transfers between cash and cash equivalents and restricted cash and restricted cash equivalents in the cash flow statement. The standard is effective for annual and interim periods beginning January 1, 2018, and is to be applied using a

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Concluded)

retrospective approach. Early adoption is permitted. TEP is evaluating the impact of this update to its financial statements and disclosures.
COMPENSATION—RETIREMENT BENEFITS
In March 2017, the FASB issued an accounting standard update to improve the presentation of net periodic benefit cost for pension and other postretirement benefits. The amendments in this update require that an employer disaggregate the service cost component from the other components of net periodic benefit cost. The guidance on the presentation of the components of net periodic benefit cost in the income statement will be applied retrospectively. The amendments also allow only the service cost component of net periodic benefit cost to be eligible for capitalization prospectively. The standard is effective for annual and interim periods beginning January 1, 2018. Early adoption is permitted. TEP is evaluating the impact of this update to its financial statements and disclosures.

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ITEM 2. 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 TEP. It includes the following:
outlook and strategies;
operating results in the second quarter and first six months of 2017 compared with the same periods of 2016;
factors affecting our results of operations and outlook;
liquidity and capital resources including contractual obligations, capital expenditures, and environmental matters;
critical accounting policies and estimates; and
recent accounting pronouncements.
Management’s Discussion and Analysis includes financial information prepared in accordance with GAAP financial measures. It also includes non-GAAP financial measures which should be viewed as a supplement to, and not a substitute for, financial measures presented in accordance with GAAP. Non-GAAP financial measures as presented herein may not be comparable to similarly titled measures used by other companies.
Management’s Discussion and Analysis should be read in conjunction with the condensed consolidated financial statements and accompanying notes that appear in Part I, Item 1 of this Form 10-Q. For information on factors that may cause our actual future results to differ from those we currently seek or anticipate, see Forward-Looking Information at the front of this report and Risk Factors in Part 1, Item 1A of our 2016 Annual Report on Form 10-K, and in Part II, Item 1A of this Form 10-Q.
References in this report to "we" and "our" are to TEP.

OUTLOOK AND STRATEGIES
TEP's financial prospects and outlook are affected by many factors including: global, national, regional, and local economic conditions; volatility in the financial markets; environmental laws and regulations; and other regulatory factors. Our plans and strategies include the following:
Achieving constructive outcomes in our regulatory proceedings that provide us: (i) recovery of our full cost of service and an opportunity to earn an appropriate return on our rate base investments; (ii) updated rates that provide more accurate price signals and a more equitable allocation of costs to our customers; and (iii) the ability to continue providing safe and reliable service.
Continuing to focus on our long-term resource diversification strategy, including shifting from coal to natural gas, renewables, and energy efficiency while providing rate stability for our customers, mitigating environmental impacts, complying with regulatory requirements, leveraging and improving our existing utility infrastructure, and maintaining financial strength. This long-term strategy includes a target of meeting 30% of our customers’ energy needs with non-carbon emitting resources by 2030.
Focusing on our core utility business through operational excellence, promoting economic development in our service territory, investing in infrastructure to ensure reliable service, and maintaining a strong community presence.
2017 Operational and Financial Highlights
For the first six months of 2017, Management's Discussion and Analysis includes the following notable items:
In February 2017, the ACC issued a decision in TEP’s rate case approving a non-fuel base rate increase of $81.5 million, a cost of equity component of 9.75%, and an equity ratio of approximately 50%. The new rates took effect on February 27, 2017.
In 2016, TEP paid a total of $17 million in time-value refunds to counterparties in compliance with FERC orders related to late-filed TSAs. In January 2017, TEP and one of the TSA counterparties entered into a settlement agreement resulting in the counterparty paying TEP $8 million and TEP dismissing a previously filed appeal. In May

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2017, the FERC informed TEP that no further enforcement actions were necessary as the related investigation was closed.
In June 2017, the Navajo Nation approved a land lease extension that allows Navajo to operate through December 2019 and decommissioning activities to begin thereafter. As a result of the planned early retirement, $38 million of Navajo’s NBV and other related costs were reclassified from Utility Plant, Net to Regulatory Assets on the Condensed Consolidated Balance Sheets as of June 30, 2017.

RESULTS OF OPERATIONS
The following discussion provides the significant items that affected TEP's results of operations in the second quarter and first six months of 2017 compared with the same periods in 2016. The significant items affecting net income are presented on an after-tax basis.
The second quarter of 2017 compared with the second quarter of 2016
TEP reported net income of $61 million in the second quarter of 2017 compared with $41 million in the second quarter of 2016. The increase of $20 million was primarily due to:
$19 million in higher retail revenue primarily due to an increase to rates as approved in the 2017 Rate Order and an increase in usage due to favorable weather;
$3 million related to the reversal of accrued refunds associated with late-filed TSAs. See Note 6 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q; and
$2 million in higher wholesale revenue primarily due to favorable pricing on wholesale contracts in 2017.
The increase was partially offset by $3 million in lower net income as a result of a valuation allowance reduction in 2016 for deferred tax assets based on a change in projected taxable income.
The first six months of 2017 compared with the first six months of 2016
TEP reported net income of $82 million in the first six months of 2017 compared with net income of $40 million in the first six months of 2016. The increase of $42 million, was primarily due to:
$22 million in higher retail revenue primarily due to an increase to rates as approved in the 2017 Rate Order and an increase in usage due to favorable weather;
$16 million in higher net income associated with late-filed TSAs. See Note 6 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q;
$5 million in higher wholesale revenue primarily due to favorable pricing on wholesale contracts in 2017; and
$3 million in lower operations and maintenance expense resulting primarily from a decrease in maintenance expense due to planned outages in 2016.
The increase was partially offset by $4 million in lower net income as a result of a valuation allowance reduction in 2016 for deferred tax assets based on a change in projected taxable income.
Retail Sales and Revenues
The following tables provide a summary of retail kWh sales, a reconciliation of Retail Revenues from Retail Margin Revenues, and weather data for the second quarter of 2017 and 2016 and for the first six months of 2017 and 2016, respectively.

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Table of Contents

Retail Revenues were $281 million in the second quarter of 2017 compared with $256 million in the second quarter of 2016. Retail Margin Revenues (non-GAAP) were $194 million in the second quarter of 2017 compared with $164 million in the second quarter of 2016.
 
Three Months Ended June 30,
 
Increase (Decrease)
 
2017
 
2016
 
Amount
 
Percent
Retail Sales by Customer Class (kWh in millions)
 
 
 
 
 
 
 
Residential
1,019

 
950

 
69

 
7.3
 %
Commercial
579

 
566

 
13

 
2.3
 %
Industrial
483

 
494

 
(11
)
 
(2.2
)%
Mining
250

 
247

 
3

 
1.2
 %
Public Authorities
4

 
7

 
(3
)
 
(42.9
)%
Total Retail Sales by Class
2,335

 
2,264

 
71

 
3.1
 %
Retail Revenues (in millions)
 
 
 
 
 
 
 
Residential
$
92

 
$
72

 
$
20

 
27.8
 %
Commercial
58

 
51

 
7

 
13.7
 %
Industrial
27

 
26

 
1

 
3.8
 %
Mining
10

 
9

 
1

 
11.1
 %
Public Authorities
1

 
1

 

 
 %
Retail Margin Revenues by Class
188

 
159

 
29

 
18.2
 %
LFCR Revenues
5

 
4

 
1

 
25.0
 %
Other Retail Margin Revenues
1

 
1

 

 
 %
Retail Margin Revenues (non-GAAP) (1)
194

 
164

 
30

 
18.3
 %
Fuel and Purchased Power Revenues
74

 
79

 
(5
)
 
(6.3
)%
DSM and RES Surcharge Revenues
13

 
13

 

 
 %
Total Retail Revenues (GAAP)
$
281

 
$
256

 
$
25

 
9.8
 %
Average Retail Margin Rate by Class (cents/kWh)
 
 
 
 
 
 
 
Residential
9.03

 
7.58

 
1.45

 
19.1
 %
Commercial
10.02

 
9.01

 
1.01

 
11.2
 %
Industrial
5.59

 
5.26

 
0.33

 
6.3
 %
Mining
4.00

 
3.64

 
0.36

 
9.9
 %
Public Authorities (2)
8.52

 
5.79

 
2.73

 
47.2
 %
Average Retail Margin Rate by Class
8.05

 
7.02

 
1.03

 
14.7
 %
Total Average Retail Margin Rate (3)
8.31

 
7.24

 
1.07

 
14.8
 %
Average Fuel and Purchased Power Rate
3.17

 
3.49

 
(0.32
)
 
(9.2
)%
Average DSM and RES Surcharge Rate
0.56

 
0.57

 
(0.01
)
 
(1.8
)%
Total Average Retail Rate
12.04

 
11.30

 
0.74

 
6.5
 %
Weather Data
 
 
 
 
 
 
 
Cooling Degree Days
 
 
 
 
 
 
 
Actual
576

 
469

 
107

 
22.8
 %
10-year Average
483

 
472

 
*

 
*

Heating Degree Days
 
 
 
 
 
 
 
Actual
25

 
23

 
2

 
8.7
 %
10-year Average
41

 
42

 
*

 
*


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Table of Contents

Retail Revenues were $480 million in the first six months of 2017 compared with $460 million in the first six months of 2016. Retail Margin Revenues (non-GAAP) were $326 million in the first six months of 2017 compared with $292 million in the first six months of 2016.
 
Six Months Ended June 30,
 
Increase (Decrease)
 
2017
 
2016
 
Amount
 
Percent
Retail Sales by Customer Class (kWh in millions)
 
 
 
 
 
 
 
Residential
1,705

 
1,647

 
58

 
3.5
 %
Commercial
1,019

 
1,006

 
13

 
1.3
 %
Industrial
928

 
947

 
(19
)
 
(2.0
)%
Mining
495

 
498

 
(3
)
 
(0.6
)%
Public Authorities
9

 
16

 
(7
)
 
(43.8
)%
Total Retail Sales by Class
4,156

 
4,114

 
42

 
1.0
 %
Retail Revenues (in millions)
 
 
 
 
 
 
 
Residential
$
149

 
$
125

 
$
24

 
19.2
 %
Commercial
95

 
86

 
9

 
10.5
 %
Industrial
49

 
50

 
(1
)
 
(2.0
)%
Mining
18

 
17

 
1

 
5.9
 %
Public Authorities
1

 
1

 

 
 %
Retail Margin Revenues by Class
312

 
279

 
33

 
11.8
 %
LFCR Revenues
11

 
9

 
2

 
22.2
 %
DSM Performance Bonus
2

 
2

 

 
 %
Other Retail Margin Revenues
1

 
2

 
(1
)
 
(50.0
)%
Retail Margin Revenues (non-GAAP) (1)
326

 
292

 
34

 
11.6
 %
Fuel and Purchased Power Revenues
128

 
145

 
(17
)
 
(11.7
)%
DSM and RES Surcharge Revenues
26

 
23

 
3

 
13.0
 %
Total Retail Revenues (GAAP)
$
480

 
$
460

 
$
20

 
4.3
 %
Average Retail Margin Rate by Class (cents/kWh)
 
 
 
 
 
 
 
Residential
8.74

 
7.59

 
1.15

 
15.2
 %
Commercial
9.32

 
8.55

 
0.77

 
9.0
 %
Industrial
5.28

 
5.28

 

 
 %
Mining
3.64

 
3.41

 
0.23

 
6.7
 %
Public Authorities (2)
7.29

 
5.64

 
1.65

 
29.3
 %
Average Retail Margin Rate by Class
7.51

 
6.78

 
0.73

 
10.8
 %
Total Average Retail Margin Rate (3)
7.84

 
7.10

 
0.74

 
10.4
 %
Average Fuel and Purchased Power Rate
3.08

 
3.52

 
(0.44
)
 
(12.5
)%
Average DSM and RES Surcharge Rate
0.63

 
0.56

 
0.07

 
12.5
 %
Total Average Retail Rate
11.55

 
11.18

 
0.37

 
3.3
 %
Weather Data
 
 
 
 
 
 
 
Cooling Degree Days
 
 
 
 
 
 
 
Actual
586

 
469

 
117

 
24.9
 %
10-year Average
484

 
473

 
*

 
*

Heating Degree Days
 
 
 
 
 
 
 
Actual
614

 
629

 
(15
)
 
(2.4
)%
10-year Average
739

 
773

 
*

 
*

* Not meaningful
(1) 
Retail Margin Revenues, a non-GAAP financial measure, should not be considered as an alternative to Retail Revenues, which is determined in accordance with GAAP. Retail Margin Revenues exclude revenues collected from retail customers that are directly

25

Table of Contents

offset by expenses recorded in other line items. We believe the change in Retail Margin Revenues between periods provides useful information for investors and analysts because it demonstrates the underlying revenue trend and performance of our core utility business. Retail Margin Revenues represents the portion of retail operating revenues from kWh sales, LFCR Revenues, DSM Performance Bonus, and certain Other Retail Margin Revenues available to cover the non-fuel operating expenses of our core utility business.
(2) 
Calculated on unrounded data and may not correspond exactly to data shown in table.
(3) 
Total Average Retail Margin Rate includes revenue related to LFCR Revenues, DSM Performance Bonus, and Other Retail Margin Revenues included in Retail Margin Revenues.
Retail Revenues increased in the second quarter and in the first six months of 2017 when compared with the same periods in 2016 primarily due to higher retail margin revenues related to an increase to rates as approved in the 2017 Rate Order and an increase in usage due to favorable weather. The increases were partially offset by a decrease in Fuel and Purchased Power Revenues related to reduced recoveries due to changes in the PPFAC rate. See Note 2 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q for additional information on the PPFAC mechanism.
Wholesale Revenues
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(in millions)
2017
 
2016
 
2017
 
2016
Long-Term Wholesale 
$
12

 
$
10

 
$
19

 
$
16

Short-Term Wholesale
20

 
16

 
47

 
30

Transmission
7

 
8

 
15

 
15

Transmission Refunds (1)
5

 

 
5

 
(13
)
Total Wholesale Revenues
$
44

 
$
34

 
$
86

 
$
48

(1) 
In 2016, FERC ordered TEP to make refunds associated with various late-filed TSAs for the time period during which rates were charged without FERC authorization. In May 2017, FERC informed TEP that no further enforcement actions were necessary as the related investigation was closed. See Note 6 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q for additional information on the FERC ordered refunds.
Wholesale Revenues increased by $10 million, or 29%, and $38 million, or 79%, in the second quarter and first six months of 2017, respectively, compared with the same periods in 2016. The increases were primarily due to: (i) time-value FERC ordered refunds in 2016 and the reversal of accrued refunds in May 2017, both related to late-filed TSAs; (ii) favorable commodity pricing on the wholesale market; and (iii) an increase in Short-Term Wholesale volumes in the first quarter of 2017.
Short-Term Wholesale Revenues are primarily related to ACC jurisdictional assets and are returned to retail customers by crediting the revenues against fuel and purchased power costs eligible for recovery through the PPFAC.
Other Revenues
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(in millions)
2017
 
2016
 
2017
 
2016
Springerville Units 3 and 4 (1)
$
19

 
$
20

 
$
38

 
$
38

Other
9

 
7

 
16

 
14

Total Other Revenues
$
28

 
$
27

 
$
54

 
$
52

(1) 
Represents revenues and reimbursements to TEP from Tri-State Generation and Transmission Association, Inc. (Tri-State), the lessee of Springerville Unit 3, and Salt River Project Agricultural Improvement and Power District (SRP), the owner of Springerville Unit 4, related to the operation of these generation facilities.
Other Revenues includes: (i) reimbursements related to Springerville Units 3 and 4; (ii) inter-company revenues from TEP's affiliates, UNS Gas and UNS Electric, for corporate services provided by TEP; and (iii) miscellaneous service-related revenues such as rent on power pole attachments, damage claims, and customer late fees.
There were no significant changes to Other Revenues in the second quarter or the first six months of 2017 when compared with the same periods in 2016.

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Operating Expenses
Generating Output and Fuel and Purchased Power Expense
TEP’s fuel and purchased power expense and energy resources are detailed in the following tables:
 
Generation and Purchased
Power (kWh)
 
Fuel and Purchased Power
Expense
 
Three Months Ended June 30,
(in millions)
2017
 
2016
 
2017
 
2016
Coal-Fired Generation
1,543

 
1,965

 
$
34

 
$
44

Gas-Fired Generation
746

 
817

 
25

 
23

Utility Owned Renewable Generation
27

 
19

 

 

Reimbursed Fuel Expense, Springerville Units 3 and 4 (1)

 

 
1

 
1

Total Generation
2,316

 
2,801

 
60

 
68

Purchased Power, Non-Renewable
862

 
366

 
33

 
10

Purchased Power, Renewable
211

 
211

 
11

 
14

Total Purchased Power
1,073

 
577

 
44

 
24

Transmission and Other PPFAC Recoverable Costs

 

 
8

 
5

Increase (Decrease) to Reflect PPFAC Recovery Treatment

 

 
(8
)
 
8

Total Generation and Purchased Power
3,389

 
3,378

 
$
104

 
$
105

Less Line Losses and Company Use
210

 
202

 
 
 
 
Total Power Sold
3,179

 
3,176

 
 
 
 
 
Six Months Ended June 30,
(in millions)
2017
 
2016
 
2017
 
2016
Coal-Fired Generation
3,552

 
3,589

 
$
82

 
$
87

Gas-Fired Generation
1,275

 
1,651

 
42

 
41

Utility Owned Renewable Generation
45

 
34

 

 

Reimbursed Fuel Expense, Springerville Units 3 and 4 (1)

 

 
3

 
3

Total Generation
4,872

 
5,274

 
127

 
131

Purchased Power, Non-Renewable
1,325

 
579

 
46

 
16

Purchased Power, Renewable
367

 
364

 
22

 
26

Total Purchased Power
1,692

 
943

 
68

 
42

Transmission and Other PPFAC Recoverable Costs

 

 
17

 
10

Increase (Decrease) to Reflect PPFAC Recovery Treatment

 

 
(16
)
 
14

Total Generation and Purchased Power
6,564

 
6,217

 
$
196

 
$
197

Less Line Losses and Company Use
365

 
352

 
 
 
 
Total Power Sold
6,199

 
5,865

 
 
 
 
(1) 
Springerville Units 3 and 4 Fuel Expense is reimbursed by Tri-State and SRP.
Fuel and Purchased Power Expense decreased by $1 million, or 1%, for both the second quarter and first six months of 2017, compared with the same periods in 2016. The decreases were primarily due to the reduction in recovery of the PPFAC costs as a result of changes in the PPFAC rate, and a decrease in Coal-Fired Generation costs as a result of unplanned outages. The decreases were partially offset by an increase in Purchased Power costs used to compensate for the decrease in Coal-Fired Generation.

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The table below summarizes average fuel cost of generated and purchased power kWh:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(cents per kWh)
2017
 
2016
 
2017
 
2016
Coal
2.21

 
2.26

 
2.30

 
2.41

Gas
3.30

 
2.80

 
3.30

 
2.52

Purchased Power, Non-Renewable
3.78

 
2.43

 
3.50

 
2.35

Purchased Power, Renewable
5.33

 
6.58

 
5.93

 
7.09

All Resources (1)
3.51

 
3.31

 
3.41

 
3.37

(1) 
Calculated on unrounded data and may not correspond exactly to data shown in Generation Output and Fuel and Purchased Power Expense table above.
Operations and Maintenance Expense
The table below summarizes the items included in Operations and Maintenance Expense:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(in millions)
2017
 
2016
 
2017
 
2016
Reimbursed Expenses, Springerville Units 3 and 4 (1)
$
14

 
$
14

 
$
26

 
$
25

Reimbursed Expenses, Customer Funded Renewable Energy and DSM Programs (2)
7

 
7

 
13

 
12

Other (3)
63

 
66

 
128

 
135

Total Operations and Maintenance Expense
$
84

 
$
87

 
$
167

 
$
172

(1) 
Expenses related to Springerville Units 3 and 4 are reimbursed with corresponding amounts recorded in Other Revenue.
(2) 
These expenses are collected from customers and the corresponding amounts are recorded in Retail Revenue.
(3) 
Includes the Third-Party Owners' share of expenses related to Springerville Unit 1 for the first six months of 2016.
Operations and Maintenance Expense decreased by $3 million, or 3%, and $5 million, or 3%, in the second quarter and first six months of 2017, respectively, compared with the same periods in 2016. The decreases were primarily due to a decrease in maintenance expense related to planned outages in 2016 and a sales tax refund in the second quarter of 2017.

FACTORS AFFECTING RESULTS OF OPERATIONS
Regulatory Matters
TEP is subject to comprehensive regulation. The discussion below contains material developments to those matters disclosed in Part II, Item 7 of our 2016 Annual Report on Form 10-K and new regulatory matters occurring in 2017.
2017 Rate Order
In February 2017, the ACC issued a rate order in the rate case filed by TEP in November 2015. TEP's rate filing was based on a test year ended June 30, 2015. The 2017 Rate Order approved new rates that went into effect on February 27, 2017.
The provisions of the 2017 Rate Order include, but are not limited to:
a non-fuel base rate increase of $81.5 million which includes $15 million of operating costs related to the 50.5% undivided interest in Springerville Unit 1 purchased by TEP in September 2016;
a 7.04% return on original cost rate base of approximately $2 billion;
a cost of equity component of 9.75% and a cost of debt component of 4.32%;
a capital structure for rate making purposes of approximately 50% common equity and 50% long-term debt;
adoption of TEP's proposed depreciation and amortization rates, which include a reduction in the depreciable life for San Juan Unit 1; and

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approval of a request to apply excess depreciation reserves against the unrecovered NBV of San Juan Unit 2 and the coal handling facilities at Sundt due to early retirement.
The ACC deferred matters related to net metering and rate design for new DG customers to Phase 2, which is currently expected to be completed in the first quarter of 2018. See Phase 2 Proceedings below.
Distributed Generation
In 2016, the ACC held proceedings under the Value and Cost of Distributed Generation docket to examine the ACC’s net metering rules and determine the value that utilities should pay DG customers who deliver electricity from rooftop solar systems back to the grid. Prior to these proceedings, the ACC’s net metering rules allowed DG customers who over-produced electricity to carry-over or “bank” excess electricity at a value equal to the full retail rate per kWh. Banked kWh could then be used by customers to offset future energy usage that could not be met by their DG system.
In December 2016, the ACC approved an order that will begin to reform net metering in Arizona. The order adopts a number of net metering changes and policies, including:
placing DG customers in a separate rate class;
grandfathering current DG customers under net metering rules and rate design for 20 years from interconnection application;
eliminating the banking of excess kWh for non-grandfathered DG customers;
compensating non-grandfathered customers for their exported kWh for 10 years at the DG export rate in effect at the time of interconnection;
updating the DG export rate annually; and
developing an avoided cost methodology for calculating the DG export rate in the utility’s next rate case.
The initial DG export rate will be established in Phase 2. See Phase 2 Proceedings below.
Phase 2 Proceedings
In March 2017, TEP filed direct testimony in its Phase 2 proceedings addressing rate design for new DG customers. The proposals include options for either a Time-Of-Use (TOU) energy rate with a basic customer service charge plus a monthly grid access fee based on the size of the DG system; or a TOU energy rate with a basic customer service charge plus a charge based on the highest hourly demand during the month. Consistent with the ACC’s decision in the Value of DG docket proceedings, TEP also proposed that: (i) new DG customers receive a bill credit for excess energy exported to the grid at an initial rate of 9.7 cents/kWh; (ii) the DG export rate be updated annually based on a five-year rolling average cost of the company’s owned and contracted utility scale renewable energy projects; (iii) customers who submit DG applications prior to the ACC’s Phase 2 decision be grandfathered under current net metering rules and rate design for a period of 20 years from the date of interconnection of their DG system; and (iv) customers who install DG after the ACC’s Phase 2 decision be compensated for 10 years at the rate in effect at the time they file an application for interconnection. A final ACC decision is currently expected by first quarter 2018. TEP cannot predict the outcome of these proceedings.
Generating Resources
As of June 30, 2017, approximately 52% of TEP's peak generation capacity is coal-fired generation. TEP is evaluating additional steps to reduce its reliance on coal-fired generation.
Integrated Resource Plan
TEP’s long-term strategy to build a more diverse, sustainable energy portfolio is described in its Integrated Resource Plan (IRP) filed in April 2017 with the ACC. TEP's 2017 IRP discusses continuing efforts to diversify its generation portfolio including expanding renewable energy and natural gas-fired resources while reducing reliance on coal-fired generating resources. TEP's existing coal generation fleet faces a number of uncertainties impacting the viability of continued operations including competition from other resources, fuel supply and land lease contract extensions, environmental regulations, and for jointly owned facilities, the willingness of other owners to continue their participation. Given this uncertainty, TEP may consider options that include changes in generation facility ownership shares, unit shutdowns, or the sale of generation assets to third-parties. TEP will seek regulatory recovery for amounts that would not otherwise be recovered, if any, as a result of these actions.

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See Part I, Item 2. Liquidity and Capital Resources, Environmental Matters of this Form 10-Q for additional information regarding the impact of environmental matters on generation facility operations.
Navajo Generating Station
In June 2017, the Navajo Nation approved a land lease extension which allows TEP and the co-owners of Navajo to continue operations through December 2019 and begin decommissioning activities thereafter. We are currently recovering Navajo capital and operating costs in base rates using a useful life through 2030. As a result of the planned early retirement of Navajo, $38 million, of the facility's NBV and other related costs were reclassified from Utility Plant, Net to Regulatory Assets on the Condensed Consolidated Balance Sheets as of June 30, 2017. We plan to seek recovery of all unrecovered costs in our next ACC rate case. Note 2 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q.
Long-Term Wholesale Sales
Navopache Electric Cooperative
In January 2017, a new long-term contract with Navopache Electric Cooperative (NEC) became effective. The contract expires at the end of 2041. TEP expects to serve 80% of NEC’s load requirements in 2017 and 100% beginning in 2018. In the six months ended June 30, 2017, revenues from the NEC contract accounted for 3% of total Wholesale Revenues on the Condensed Consolidated Statements of Income.
Interest Rates
See Part II, Item 7A in our 2016 Annual Report on Form 10-K and Part II, Item 3 of this Form 10-Q for information regarding interest rate risks and its impact on earnings.

LIQUIDITY AND CAPITAL RESOURCES
Liquidity
Cash flows may vary during the year with cash flows from operations typically the lowest in the first quarter of the year and highest in the third quarter due to TEP’s summer peaking load. As a result of the varied seasonal cash flow, we will use, as needed, our revolving credit facility to assist in funding business activities. We believe that we have sufficient liquidity under our revolving credit facility to meet short-term working capital needs and to provide credit enhancement as necessary under energy procurement and hedging agreements. The availability and terms under which TEP has access to external financing depends on a variety of factors, including its credit ratings and conditions in the overall capital markets.
Available Liquidity
(in millions)
June 30, 2017
Cash and Cash Equivalents
$
15

Amount Available under Revolving Credit Facility (1)
250

Total Liquidity
$
265

(1) 
TEP's revolving credit facility provides for $250 million of revolving credit commitments with a LOC sublimit of $50 million through its original maturity date of October 2020. In October 2016, TEP extended the agreement one year to October 2021. The credit facility commitments will be reduced to $217.5 million in the final year of the agreement.
Future Liquidity Requirements
We expect to meet all of our financial obligations and other anticipated cash outflows for the foreseeable future. These obligations and anticipated cash outflows include, but are not limited to, dividend payments, debt maturities, and obligations included in the Contractual Obligations and forecasted Capital Expenditures tables reported in our 2016 Annual Report on Form 10-K and the material changes summarized below in the respective sections.

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Summary of Cash Flows
The table below presents net cash provided by (used for) operating, investing, and financing activities:
 
Six Months Ended June 30,
 
Increase (Decrease)
(in millions)
2017
 
2016
 
Percent
Operating Activities
$
170

 
$
157

 
8.3
 %
Investing Activities
(177
)
 
(156
)
 
13.5
 %
Financing Activities
(14
)
 
(18
)
 
(22.2
)%
Net Decrease in Cash and Cash Equivalents
(21
)
 
(17
)
 
(23.5
)%
Cash and Cash Equivalents, Beginning of Period
36

 
56

 
(35.7
)%
Cash and Cash Equivalents, End of Period
$
15

 
$
39

 
(61.5
)%
Operating Activities
In the first six months of 2017, net cash flows from operating activities increased by $13 million compared with the same period in 2016. The increase is primarily due to $8 million in higher cash proceeds received in 2017 from a settlement agreement with counterparties related to the late-filed TSAs and higher net income due to an increase in: (i) rates as approved in the 2017 Rate Order; and (ii) residential usage due to favorable weather. The increase was partially offset by changes in working capital related to the timing of billing collections and payments.
Investing Activities
In the first six months of 2017, net cash flows used for investing activities increased by $21 million compared with the same period in 2016 primarily due to an increase in cash paid for capital expenditures.
Financing Activities
In the first six months of 2017, net cash flows used for financing activities did not vary significantly compared with the same period in 2016.
External Sources of Liquidity
Short-Term Investments
Our short-term investment policy governs the investment of excess cash balances. We periodically review and update this policy in response to market conditions. As of June 30, 2017, TEP's short-term investments included highly-rated and liquid money market funds.
Access to Revolving Credit Facility
We have access to working capital through a revolving credit agreement with lenders. TEP expects that amounts borrowed under the credit agreement will be used for working capital and other general corporate purposes and that LOCs will be issued from time to time to support energy procurement and hedging transactions. As of June 30, 2017, there was $250 million available under the revolving credit commitments and LOC facilities. As of July 27, 2017, TEP had $230 million available under its revolving credit commitments and LOC facility.
For details of TEP's credit facility see Note 6 of Notes to Consolidated Financial Statements in Part II, Item 8 in our 2016 Annual Report on Form 10-K.
Debt Financing
We use debt financing to meet a portion of our capital needs and lower our overall cost of capital. We are exposed to adverse changes in interest rates to the extent that we rely on variable rate financing. Our cost of capital is also affected by our credit ratings.
In 2016, the ACC issued an order granting TEP financing authority. The order extends and expands the previous financing authority by: (i) extending authority from December 2016 to December 2020; (ii) increasing the outstanding long-term debt limitation from $1.7 billion to $2.2 billion; (iii) allowing parent equity contributions of up to $400 million; and (iv) continuing the interest rate hedging authority.

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We have no plans to raise additional capital in 2017. TEP has, from time to time, refinanced or repurchased portions of its outstanding debt before scheduled maturity. Depending on market conditions, TEP may refinance other debt issuances or make additional debt repurchases in the future.
Credit Ratings
Credit ratings affect our access to capital markets and supplemental bank financing. In April 2017, S&P Global Ratings upgraded TEP’s credit rating on senior unsecured debt to A- from BBB+, and as of June 30, 2017 the credit rating remained unchanged. As of June 30, 2017, Moody’s Investors Service credit ratings for TEP’s senior unsecured debt remained unchanged at A3.
TEP's credit ratings are dependent on a number of factors, both quantitative and qualitative, and are subject to change at any time. The disclosure of these credit ratings is not a recommendation to buy, sell, or hold TEP securities. Each rating should be evaluated independently of any other ratings.
Debt Covenants
Certain of TEP's debt agreements contain pricing based on TEP’s credit ratings. A change in TEP’s credit ratings can cause an increase or decrease in the amount of interest TEP pays on its borrowings, and the amount of fees it pays for its LOCs and unused commitments. Also, under certain agreements, should TEP fail to maintain compliance with covenants, lenders could accelerate the maturity of all amounts outstanding. As of June 30, 2017, TEP was in compliance with these covenants.
We do not have any provisions in any of our debt or lease agreements that would cause an event of default or cause amounts to become due and payable in the event of a credit rating downgrade.
Master Trading Agreements
TEP conducts its wholesale marketing and risk management activities under certain master agreements. Under these agreements, TEP may be required to post credit enhancements in the form of cash or an LOC due to exposures exceeding unsecured credit limits provided to TEP, changes in contract values, changes in TEP’s credit ratings, or material changes in TEP’s creditworthiness. As of June 30, 2017, TEP had posted no LOCs as credit enhancements with its counterparties.
Contribution from Parent
TEP received no equity contributions in the three and six months ended June 30, 2017 or 2016.
Dividends Paid to Parent
TEP did not declare or pay dividends to UNS Energy in the three and six months ended June 30, 2017 or 2016. On July 24, 2017, TEP declared a $35 million dividend to UNS Energy to be paid by July 28, 2017.
Capital Expenditures
TEP's capital expenditures include funds used for customer growth, system reinforcement, replacements and betterments, and costs to comply with environmental rules and regulations. Our capital expenditures in the first six months of 2017 were $151 million compared to $135 million for the same period 2016. TEP's forecasted capital expenditures are summarized below:
(in millions)
2017
 
2018
 
2019
 
2020
 
2021
Generation Facilities:
 
 
 
 
 
 
 
 
 
Environmental Compliance
$
23

 
$
11

 
$
1

 
$
2

 
$

Renewable Energy
6

 
15

 
21

 
26

 
26

Springerville Common Lease Purchase
38

 

 

 

 
9

Replacement Generation Capacity (1)
13

 
132

 
190

 
53

 
29

Other Generation Facilities
41

 
80

 
35

 
76

 
63

Total Generation Facilities
121

 
238

 
247

 
157

 
127

Transmission and Distribution
167

 
176

 
161

 
169

 
162

General and Other (2)
76

 
76

 
106

 
53

 
39

Total Capital Expenditures
$
364

 
$
490

 
$
514

 
$
379

 
$
328

(1) 
Investments that will provide replacement capacity for planned coal-fired generation retirements.

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(2) 
Includes cost for information technology, fleet, facilities, and communication equipment.
These estimates are subject to continuing review and adjustment. Actual capital expenditures may differ from these estimates due to fluctuations in business and market conditions, construction schedules, possible early plant closures, changes in generation resources, environmental requirements, state or federal regulations, and other factors. We expect to pay for forecasted capital expenditures with internally generated funds and external financings, which may include issuances of long-term debt or other borrowings.
Contractual Obligations
In the first six months of 2017, there have been no material changes outside the ordinary course of business to contractual obligations as reported in our 2016 Annual Report on Form 10-K.
Off-Balance Sheet Arrangements
Other than the unrecorded contractual obligations reported on the contractual obligations table presented in our 2016 Annual Report on Form 10-K, we do not have any arrangements or relationships with entities that are not consolidated into the financial statements.
Income Tax Position
Prior year tax legislation and the Consolidated Appropriations Act of 2016 include provisions that make qualified property placed in service between 2010 and 2019 eligible for bonus depreciation for tax purposes. In addition, the IRS issued new guidance related to the treatment of expenditures to maintain, replace, or improve property. These provisions are an acceleration of tax benefits TEP otherwise would have received over 20 years and have created net operating loss carryforwards that can be used to offset future taxable income. As a result, TEP did not pay any federal or state income taxes in the first six months of 2017 and does not expect to make any payments until 2020.
Environmental Matters
The Environmental Protection Agency (EPA) regulates the amount of sulfur dioxide (SO2), nitrogen oxide (NOx), carbon dioxide (CO2), particulate matter, mercury and other by-products produced by generation facilities. TEP may incur additional costs to comply with future changes in federal and state environmental laws, regulations, and permit requirements at its generation facilities. Environmental laws and regulations are subject to a range of interpretations, which may ultimately be resolved by the courts. Because these laws and regulations continue to evolve, TEP is unable to predict the impact of the changing laws and regulations on its operations and consolidated financial results. Complying with these changes may reduce operating efficiency. TEP expects to recover the cost of environmental compliance through Retail Rates.
Regional Haze Rules
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 in national parks and wilderness areas. The rule calls for all states to establish goals and emission reduction strategies for improving visibility. States must submit these goals and strategies to the EPA for approval. Because Navajo and Four Corners are located on land leased from the Navajo Nation, they are not subject to state oversight; the EPA oversees regional haze planning for these generation facilities.
In the western United States, Regional Haze BART determinations have focused on controls for NOx, often resulting in a requirement to install Selective Catalytic Reduction. The costs to comply with the BART rule, and with other future environmental rules, may make it economically impractical to continue operating all or a portion of Navajo and Four Corners or for individual owners to continue to participate in these generation facilities. The BART provisions do not apply to Springerville Units 1 and 2 since they were constructed in the 1980s, after the time frame as designated by the rules. Other provisions of the Regional Haze Rules requiring further emission reductions are not likely to impact Springerville operations until after 2021. In December 2016, the EPA signed a final rule, entitled "Protection of Visibility: Amendments to Requirements for State Plans." Among other things, the rule changes the date for submittal of the next regional haze implementation plan from 2018 to 2021. Based on recent Regional Haze requirement time-frames, TEP anticipates that impacts, if any, to Springerville will likely occur three to five years after the 2021 plan submittal date. TEP cannot predict the ultimate outcome of these matters.
Four Corners
In December 2013, APS, on behalf of the co-owners of Four Corners, notified the EPA that they have chosen an alternative BART compliance strategy. As a result, APS closed Units 1, 2, and 3 in December 2013 and agreed to the installation of

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Selective Catalytic Reduction (SCR) on Units 4 and 5 by July 2018. TEP owns 7% of Four Corners Units 4 and 5. TEP's estimated share of NOx emissions control costs to comply with the rules is $44 million in capital expenditures and $2 million in annual operations and maintenance expenses.
Navajo
In August 2014, the EPA published a final Federal Implementation Plan (FIP) which provides that one unit at Navajo will be shut down by 2020, SCR, or the equivalent, will be installed on the remaining two units by 2030, and conventional coal-fired generation will cease by December 2044. The final BART rule includes options that accommodate potential ownership changes at the facility. The facility has until December 2019 to notify the EPA of how it will comply with the FIP.
In June 2017, the Navajo Nation approved a land lease extension which allows TEP and the co-owners of Navajo to continue operations through December 2019 and begin decommissioning activities thereafter. As a result of the early retirement of Navajo, TEP and the co-owners will no longer be responsible for implementing the FIP. See Note 1 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q for additional information related to the early retirement of Navajo.
San Juan
In October 2014, the EPA published a final rule approving a revised SIP covering BART requirements for San Juan, which includes the closure of Units 2 and 3 by December 2017 and the installation of Selective Non-Catalytic Reduction (SNCR) on Units 1 and 4. TEP owns 50% of Units 1 and 2 at San Juan. Public Service Company of New Mexico (PNM), the operator of San Juan, completed the installation of SNCR in February 2016. PNM obtained New Mexico Public Regulation Commission approval to shut down Units 2 and 3 at San Juan.
In anticipation of the retirement of San Juan Unit 2 in December 2017, TEP applied excess depreciation reserves against the unrecovered NBV as approved in the 2017 Rate Order. See Note 1 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q for additional information related to the retirement of San Juan Unit 2.
Sundt
In June 2014, the EPA issued a final rule that required TEP to either: (i) install, by mid-2017, SNCR and dry sorbent injection if Sundt Unit 4 continued to use coal as a fuel source; or (ii) permanently eliminate coal as a fuel source as a better-than-BART alternative by the end of 2017. Under the rule, TEP was required to notify the EPA of its decision by March 2017.
In March 2016, TEP notified the EPA of its decision to permanently eliminate coal as a fuel source to comply with the better-than-BART alternative emission limits. TEP applied excess depreciation reserves against the unrecovered NBV of the coal handling facilities at Sundt as approved in the 2017 Rate Order. See Note 1 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q for additional information related to the retirement of the coal handling facilities at Sundt.
Greenhouse Gas Regulation
In August 2015, the EPA issued the CPP limiting CO2 emissions from existing and new fossil fueled generation facilities. The Clean Power Plan (CPP) establishes state-level CO2 emission rates and mass-based goals that apply to fossil fuel-fired generation. The plan targets CO2 emissions reductions for existing facilities by 2030 and establishes interim goals that begin in 2022. States were required to develop and submit a final compliance plan, or an initial plan with an extension request, to the EPA by September 2016. States that received an extension are required to submit a final completed plan to the EPA by September 2018.
The EPA incorporated the compliance obligations for existing generation facilities located in Indian Country, like the Navajo Nation, in the existing sources rule and a newly proposed Federal Plan using a compliance method similar to that of the states. The proposed Federal Plan would be implemented for any Indian nation and/or state that does not submit a plan or that does not have an EPA or state approved plan. TEP will work with the participants at Four Corners and Navajo to determine how this revision may impact compliance and operations at both facilities. TEP has submitted comments on the proposed Federal Plan impacting our facilities, including Four Corners and Navajo, stating, among other things, that the EPA should not regulate the greenhouse gases on the Navajo Nation because it is not appropriate or necessary. The reduction of greenhouse gases achieved due to the shutdowns resulting from compliance with the Regional Haze Rules will be equivalent to those required under the CPP rule.
TEP's compliance requirements under the CPP are subject to the outcomes of potential proceedings and litigation challenging the rule. In February 2016, the U.S. Supreme Court granted a stay effectively ordering the EPA to stop CPP implementation

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efforts until legal challenges to the regulation have been resolved. The ruling introduces uncertainty as to whether and when the states and utilities will have to comply with the CPP rule.
In September 2016, the U.S. Court of Appeals for the District of Columbia Circuit (U.S. Court of Appeals) heard oral arguments on the CPP. On March 28, 2017, the Department of Justice filed a motion to hold the lawsuits related to the CPP in abeyance. On April 28, 2017, the U.S. Court of Appeals granted that motion and delayed for 60 days litigation over the EPA's CPP for existing and new generation facilities. The EPA has asked for an extension.
On March 28, 2017, a Presidential Executive Order (EO) titled "Promoting Energy Independence and Economic Growth" was issued. The EO instructs the EPA to review the final greenhouse gas rule for existing and new and modified generation facilities and either suspend, revise, or rescind the rule as appropriate. In April 2017, the EPA announced in the Federal Register that it is reviewing and, if appropriate, will initiate proceedings to suspend, revise, or rescind the CPP rule. In June 2017, the EPA sent the Office of Management and Budget a draft proposed rule for review. The contents of the proposed rule are not known at this time.
TEP will continue to work with the Arizona Department of Environmental Quality (ADEQ) to determine what, if any, actions need to be taken in light of recent events. TEP cannot predict the ultimate outcome of these matters.
Coal Combustion Residuals Regulation
In April 2015, the EPA issued a final rule requiring all coal ash and other coal combustion residuals to be treated as a solid waste under Subtitle D of the Resource Conservation and Recovery Act (RCRA Subtitle D) for disposal in landfills and/or surface impoundments while allowing for the continued recycling of coal ash. TEP does not operate any impoundments. Under the rule, the Springerville ash landfill is classified as an existing landfill and is not subject to the lateral expansion requirements. However, TEP will incur additional costs for site preparation and monitoring at Springerville to be fully compliant with the rule. TEP’s share of costs at Springerville is estimated to be $2 million, the majority of which is expected to be capital expenditures. TEP currently estimates its share of costs to be $5 million at Four Corners, $3 million at Navajo, and less than $1 million at San Juan, the majority of which are expected to be capital expenditures.
In December 2016, Congress approved the Water Infrastructure Improvements for the Nation Act which authorizes the States to establish permit programs under RCRA Subtitle D for implementing regulation for Coal Combustion Residuals (CCR). TEP is currently working with other affected utilities and the ADEQ to explore the possibility of developing a State administered program to enforce CCR regulation.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's Discussion and Analysis of Financial Condition and Results of Operations is based on our Condensed Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires management to apply accounting policies and make estimates, judgments, and assumptions that affect the reported amounts of assets, liabilities, net revenues and expenses, and disclosure of contingent liabilities. Management believes that there have been no significant changes during the six months ended June 30, 2017, to the items that we disclosed as our critical accounting policies and estimates in Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in our 2016 Annual Report on Form 10-K.

ACCOUNTING PRONOUNCEMENTS
For a discussion of new accounting pronouncements affecting TEP, see Note 10 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q.


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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
TEP’s primary market risks include fluctuations in interest rates, commodity prices and volumes, and counterparty credit. Fluctuations in interest rates can affect earnings and cash flows. We can enter into interest rate swaps and financing transactions to manage changes in interest rates. Fluctuations in commodity prices and volumes and counterparty credit losses may temporarily affect cash flows, but are not expected to affect earnings due to expected recovery through regulatory mechanisms.
There have been no additional risks and no material changes to market risks disclosed in Part II, Item 7A in our 2016 Annual Report on Form 10-K.

ITEM 4. CONTROLS AND PROCEDURES
TEP’s Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal financial officer) supervised and participated in TEP’s evaluation of its disclosure controls and procedures as such term is defined under Rule 13(a) – 15(e) or Rule 15(d) – 15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act), as of the end of the period covered by this report. Disclosure controls and procedures are controls and procedures designed to ensure that information required to be disclosed in TEP’s periodic reports filed or submitted under the Exchange Act, is recorded, processed, summarized, and reported within the time periods specified in the United States SEC’s rules and forms. These disclosure controls and procedures are also designed to ensure that information required to be disclosed by TEP in the reports that it files or submits under the Exchange Act is accumulated and communicated to management, including the principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Based upon the evaluation performed, TEP’s Chief Executive Officer and Chief Financial Officer concluded that TEP’s disclosure controls and procedures are effective as of June 30, 2017.
While TEP continually strives to improve its disclosure controls and procedures to enhance the quality of its financial reporting, there has been no change in TEP’s ICFR during the quarter ended June 30, 2017, that has materially affected, or is reasonably likely to materially affect, TEP’s IFCR.


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PART II
ITEM 1. LEGAL PROCEEDINGS
For a description of certain legal proceedings affecting TEP, refer to Note 6 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q.

ITEM 1A. RISK FACTORS
The business and financial results of TEP are subject to numerous risks and uncertainties. As a result, the risks and uncertainties discussed in Part I, Item 1A. Risk Factors in our 2016 Form 10-K should be carefully considered. There have been no material changes in the assessment of our risk factors from those set forth in our 2016 Form 10-K.

ITEM 5. OTHER INFORMATION

RATIO OF EARNINGS TO FIXED CHARGES
 
Six Months Ended
 
Twelve Months Ended
 
June 30, 2017
 
June 30, 2017
Ratio of Earnings to Fixed Charges
4.53

 
4.67

For purposes of this computation, earnings are defined as pre-tax earnings from continuing operations before minority interest, or income/loss from equity method investments, plus interest expense and amortization of debt discount and expense related to indebtedness. Fixed charges are interest expense, including amortization of debt discount and expense, interest on operating lease payments, and expense on indebtedness, including capital lease obligations.

ITEM 6. EXHIBITS
See Exhibit Index.


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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
TUCSON ELECTRIC POWER COMPANY
 
 
 
(Registrant)
 
 
 
 
Date:
July 28, 2017
 
/s/ Frank P. Marino
 
 
 
Frank P. Marino
 
 
 
Vice President and Chief Financial Officer
 
 
 
(Principal Financial Officer)


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EXHIBIT INDEX
12
 
 
Computation of Ratio of Earnings to Fixed Charges
 
 
 
31(a)
 
 
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act, by David G. Hutchens
 
 
 
31(b)
 
 
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act, by Frank P. Marino
 
 
 
*32
 
 
Statements of Corporate Officers (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)
 
 
 
101.INS
 
 
XBRL Instance Document
 
 
 
 
 
101.SCH
 
 
XBRL Taxonomy Extension Schema Document
 
 
 
 
 
101.CAL
 
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
 
 
 
101.LAB
 
 
XBRL Taxonomy Extension Label Linkbase Document
 
 
 
 
 
101.PRE
 
 
XBRL Taxonomy Extension Presentation Linkbase Document
 
 
 
 
 
101.DEF
 
 
XBRL Taxonomy Extension Definition Linkbase Document
*
Pursuant to Item 601(b)(32)(ii) of Regulation S-K, this certificate is not being “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.


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