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 ~~September 30, 2016~~March 31, 2017

¨ 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



~~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		xNo o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, ~~or a~~ smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” ~~and~~ “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



~~Large Accelerated Filer~~	o	~~Accelerated Filer~~	o	~~Non-accelerated Filer~~	x	~~Smaller Reporting 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		oNo 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 ~~November 3, 2016.~~May 1, 2017.

Table of Contents

DEFINITIONS

The abbreviations and acronyms used in the ~~third~~first quarter ~~2016~~2017 Form 10-Q are defined below:



~~2013~~2017 Rate Order		A rate order issued by the ACC resulting in a new rate structure for TEP, effective ~~July 1, 2013~~
~~2015 Rate Case~~		~~A pending general rate case filed with the ACC by TEP in November 2015 requesting new rates effective January 1,~~on February 27, 2017
ACC		Arizona Corporation Commission
APS		Arizona Public Service Company
BART		Best Available Retrofit Technology
BBtu		Billion British thermal units
~~CDD~~DG		~~Cooling Degrees Days is 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~~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
~~Gila River~~		~~Gila River Generating Station~~
GWh		Gigawatt-hour(s)
HDD		Heating Degree Days is 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
~~Luna~~		~~Luna Generating Station~~
~~MATS~~		~~Mercury and Air Toxics Standards~~
~~MMBtu~~		~~Million British thermal units~~
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 to recover its costs of providing services and an opportunity to earn a reasonable return on its investment
San Juan		San Juan Generating Station
~~SCR~~		~~Selective Catalytic Reduction~~
SES		Southwest Energy Solutions, Inc.
SJCC		San Juan Coal Company
~~SNCR~~		~~Selective Non-Catalytic Reduction~~
Springerville		Springerville Generating Station
~~Springerville Coal Handling Facilities~~		~~Coal handling facilities at Springerville used by all four Springerville units~~

~~iii~~



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)
TSA		Transmission Service Agreement
~~Tri-State~~		~~Tri-State Generation and Transmission Association, Inc.~~
~~UES~~		~~UniSource Energy Services, Inc., a wholly-owned subsidiary of UNS Energy Corporation, and intermediate holding company established to own the operating companies UNS Electric, Inc. and UNS Gas, Inc.~~
UNS Electric		UNS Electric, Inc., an indirect wholly-owned subsidiary of UNS Energy Corporation

iii



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

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) 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, 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 ~~2015~~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 retiree 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,~~cyber-attacks, data breaches, or other challenges to our information ~~security;~~security, including our operations and technology systems; and the performance of TEP's generating plants.

Table of Contents

PART I

ITEM 1. FINANCIAL STATEMENTS

TUCSON ELECTRIC POWER COMPANY

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)(Unaudited)

(Amounts in thousands)


	Three Months Ended September 30,						Nine Months Ended September 30,						Three Months Ended March 31,
	2016			2015			2016			2015			2017			2016
Operating Revenues
Retail	$	320,379		$	337,284		$	780,782		$	803,204		$	199,506		$	203,953
Wholesale	32,151			40,545			80,648			129,681			42,538			16,631
Other	41,605			30,915			93,668			89,427			26,338			25,113
Total Operating Revenues	394,135			408,744			955,098			1,022,312			268,382			245,697
Operating Expenses
Fuel	86,530			91,853			217,444			239,489			66,728			62,678
Purchased Power	30,031			40,378			71,794			107,785			24,295			19,958
Transmission and Other PPFAC Recoverable Costs	7,143			7,386			17,633			18,966			8,899			5,178
Increase to Reflect PPFAC Recovery Treatment	5,091			9,846			19,356			20,627
Increase (Decrease) to Reflect PPFAC Recovery Treatment													(8,190		)	6,795
Total Fuel and Purchased Power	128,795			149,463			326,227			386,867			91,732			94,609
Operations and Maintenance	88,699			88,155			260,278			256,455			82,141			84,999
Depreciation	36,565			34,395			108,110			103,347			38,157			35,632
Amortization	5,558			4,342			16,579			14,523			5,402			5,476
Taxes Other Than Income Taxes	12,646			12,038			38,376			38,184			13,800			13,030
Total Operating Expenses	272,263			288,393			749,570			799,376			231,232			233,746
Operating Income	121,872			120,351			205,528			222,936			37,150			11,951
Other Income (Deductions)
Interest Income	11			26			78			77			93			38
Other Income	1,774			2,408			4,427			4,466			9,020			1,393
Other Expense	(1,166		)	(983		)	(2,052		)	(2,101		)	(761		)	(423		)
Appreciation (Depreciation) in Value of Investments	722			(1,277		)	1,582			(1,036		)
Appreciation in Value of Investments													734			200
Total Other Income (Deductions)	1,341			174			4,035			1,406			9,086			1,208
Interest Expense
Long-Term Debt	15,545			15,630			46,522			45,746			15,436			15,491
Capital Leases	821			991			2,534			3,003			664			858
Other Interest Expense	114			125			372			989			215			123
Interest Capitalized	(436		)	(781		)	(1,297		)	(1,977		)	(530		)	(464		)
Total Interest Expense	16,044			15,965			48,131			47,761			15,785			16,008
Income Before Income Taxes	107,169			104,560			161,432			176,581
Income Tax Expense	35,556			36,021			49,985			60,787
Net Income	$	71,613		$	68,539		$	111,447		$	115,794
Income (Loss) Before Income Taxes													30,451			(2,849		)
Income Tax Expense (Benefit)													9,692			(2,147		)
Net Income (Loss)													$	20,759		$	(702	)

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

TUCSON ELECTRIC POWER COMPANY

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)(Unaudited)

(Amounts in thousands)

Three Months Ended September 30, Nine Months Ended September 30,
2016 2015 2016 2015
Comprehensive Income
Net Income $ 71,613
$ 68,539
$ 111,447
$ 115,794
Other Comprehensive Income
Net Changes in Fair Value of Cash Flow Hedges:
Net of Income Tax Expense of $155 and $289 247
452

Net of Income Tax Expense of $242 and $583 385
908
Supplemental Executive Retirement Plan Adjustments:
Net of Income Tax Expense of $34 and $38 55
60

Net of Income Tax Expense of $104 and $113 168
181
Total Other Comprehensive Income, Net of Tax 302
512
553
1,089
Total Comprehensive Income $ 71,915
$ 69,051
$ 112,000
$ 116,883



	Three Months Ended March 31,
	2017		2016
Comprehensive Income (Loss)
Net Income (Loss)	$	20,759	$	(702	)
Other Comprehensive Income
Net Changes in Fair Value of Cash Flow Hedges:
Net of Income Tax Expense of $74 and $6	119		9
Supplemental Executive Retirement Plan Adjustments:
Net of Income Tax Expense of $43 and $35	70		56
Total Other Comprehensive Income Net of Tax	189		65
Total Comprehensive Income (Loss)	$	20,948	$	(637	)

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

TUCSON ELECTRIC POWER COMPANY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Amounts in thousands)


	Nine Months Ended September 30,						Three Months Ended March 31,
	2016			2015			2017			2016
Cash Flows from Operating Activities
Net Income	$	111,447		$	115,794
Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities:
Net Income (Loss)							$	20,759		$	(702	)
Adjustments to Reconcile Net Income (Loss) to Net Cash Flows from Operating Activities:
Depreciation Expense	108,110			103,347			38,157			35,632
Amortization Expense	16,579			14,523			5,402			5,476
Amortization of Debt Issuance Costs	2,176			2,288			589			726
Use of Renewable Energy Credits for Compliance	13,048			16,139			5,385			3,518
Deferred Income Taxes	49,972			61,083			9,709			(2,149		)
Pension and Retiree Expense	11,504			13,941
Pension and Retiree Funding	(12,672		)	(28,922		)
Share-Based Compensation Expense	1,571			862
Pension and Other Postretirement Benefits Expense							4,010			3,835
Pension and Other Postretirement Benefits Funding							(1,088		)	(1,582		)
Allowance for Equity Funds Used During Construction	(3,410		)	(3,391		)	(1,358		)	(1,171		)
FERC Transmission Refund Payable	18,783			—			180			13,314
Changes in Current Assets and Current Liabilities:
Accounts Receivable	(24,743		)	(47,514		)	15,875			29,780
Materials, Supplies, and Fuel Inventory	8,366			(7,450		)	1,051			2,593
Regulatory Assets	(7,533		)	17,294			(6,063		)	(5,680		)
Accounts Payable and Accrued Charges	23,139			15,108			11,409			150
Regulatory Liabilities	21,648			(4,232		)	(7,342		)	5,294
Other, Net	3,462			(2,801		)	1,373			5,696
Net Cash Flows—Operating Activities	341,447			266,069			98,048			94,730
Cash Flows from Investing Activities
Capital Expenditures	(187,678		)	(259,638		)	(78,809		)	(72,837		)
Purchase, Springerville Coal Handling Facilities Lease Assets	—			(120,312		)
Proceeds from Sale, Springerville Coal Handling Facilities	—			23,656
Purchase, Springerville Unit 1 Assets	(85,000		)	(45,753		)
Purchase Intangibles, Renewable Energy Credits	(31,192		)	(22,672		)	(11,051		)	(7,701		)
Contributions in Aid of Construction	1,965			5,761			929			(456		)
Net Cash Flows—Investing Activities	(301,905		)	(418,958		)	(88,931		)	(80,994		)
Cash Flows from Financing Activities
Proceeds from Borrowings Under Revolving Credit Facilities	—			148,000
Repayments of Borrowings Under Revolving Credit Facilities	—			(233,000		)
Proceeds from Borrowings Under Term Loan	—			130,000
Repayments of Borrowings Under Term Loan	—			(130,000		)
Proceeds from Issuance of Long-Term Debt	—			299,019
Repayments of Long-Term Debt	—			(208,600		)
Dividend Paid to Parent	(20,000		)	(25,000		)
Payments of Capital Lease Obligations	(14,080		)	(13,464		)	(10,310		)	(9,039		)
Payment of Debt Issuance/Retirement Costs	—			(2,987		)
Contribution from Parent	—			180,000
Other, Net	(4,107		)	1,659			285			30
Net Cash Flows—Financing Activities	(38,187		)	145,627			(10,025		)	(9,009		)
Net Increase (Decrease) in Cash and Cash Equivalents	1,355			(7,262		)	(908		)	4,727
Cash and Cash Equivalents, Beginning of Period	55,684			74,170			35,962			55,684
Cash and Cash Equivalents, End of Period	$	57,039		$	66,908		$	35,054		$	60,411

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

TUCSON ELECTRIC POWER COMPANY

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

(Amounts in ~~thousands)~~thousands, except share data)


	September 30,			December 31,			March 31,			December 31,
	2016			2015			2017			2016
ASSETS
Utility Plant
Plant in Service	$	5,869,080		$	5,618,435		$	5,780,279		$	5,975,139
Utility Plant Under Capital Leases	131,705			131,705			167,413			167,413
Construction Work in Progress	140,287			102,028			163,155			129,955
Total Utility Plant	6,141,072			5,852,168			6,110,847			6,272,507
Accumulated Depreciation and Amortization	(2,346,149		)	(2,194,301		)	(2,169,607		)	(2,385,053		)
Accumulated Amortization of Capital Lease Assets	(103,362		)	(99,638		)	(106,323		)	(104,648		)
Total Utility Plant, Net	3,691,561			3,558,229			3,834,917			3,782,806

Investments and Other Property	41,177			39,569			45,918			45,020

Current Assets
Cash and Cash Equivalents	57,039			55,684			35,054			35,962
Accounts Receivable, Net	155,748			136,682			108,889			124,934
Fuel Inventory	26,849			34,600			24,631			25,887
Materials and Supplies	94,242			94,003			99,379			97,126
Regulatory Assets	52,951			51,841			59,530			56,340
Derivative Instruments	3,976			1,808			3,914			4,966
Assets Held for Sale, Net	21,550			21,550
Other	15,097			25,904			12,746			13,793
Total Current Assets	427,452			422,072			344,143			359,008
Regulatory and Other Assets
Regulatory Assets	218,078			212,312			220,827			225,453
Derivative Instruments	271			430			111			330
Other	38,270			16,866			40,737			37,372
Total Regulatory and Other Assets	256,619			229,608			261,675			263,155
Total Assets	$	4,416,809		$	4,249,478		$	4,486,653		$	4,449,989

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

(Continued)

TUCSON ELECTRIC POWER COMPANY

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

(Amounts in ~~thousands)~~thousands, except share data)


	September 30,			December 31,			March 31,			December 31,
	2016			2015			2017			2016
CAPITALIZATION AND OTHER LIABILITIES
Capitalization
Common Stock Equity:
Common Stock (No Par Value, 75,000 Shares Authorized, 32,139 Shares Outstanding at September 30, 2016 and December 31, 2015)	$	1,296,539		$	1,296,539
Common Stock (No Par Value, 75,000,000 Shares Authorized, 32,139,434 Shares Outstanding as of March 31, 2017 and December 31, 2016)							$	1,296,539		$	1,296,539
Capital Stock Expense	(6,357		)	(6,357		)	(6,357		)	(6,357		)
Retained Earnings	280,764			189,317			294,167			273,408
Accumulated Other Comprehensive Loss	(4,011		)	(4,564		)	(4,366		)	(4,555		)
Total Common Stock Equity	1,566,935			1,474,935			1,579,983			1,559,035
Preferred Stock (No Par Value, 1,000 Shares Authorized, None Outstanding at September 30, 2016 and December 31, 2015)	—			—
Preferred Stock (No Par Value, 1,000,000 Shares Authorized, None Outstanding as of March 31, 2017 and December 31, 2016)							—			—
Capital Lease Obligations	39,126			55,324			28,164			39,267
Long-Term Debt, Net	1,452,734			1,451,720			1,453,409			1,453,072
Total Capitalization	3,058,795			2,981,979			3,061,556			3,051,374
Current Liabilities
Current Obligations Under Capital Leases	15,471			14,114
Capital Lease Obligations							52,263			51,765
Accounts Payable	95,868			86,274			87,469			89,797
Accrued Taxes Other than Income Taxes	56,146			37,577			49,948			37,639
Accrued Employee Expenses	23,419			27,718			18,966			29,465
Accrued Interest	12,689			14,246			13,121			14,508
Regulatory Liabilities	76,533			53,077			69,199			76,069
Customer Deposits	22,162			20,349			26,473			25,778
Derivative Instruments	3,501			12,174			2,930			2,641
Other	14,987			7,533			23,021			17,837
Total Current Liabilities	320,776			273,062			343,390			345,499
Regulatory and Other Liabilities
Deferred Income Taxes, Net	524,580			468,024			539,908			529,148
Regulatory Liabilities	302,881			307,286			308,825			300,700
Pension and Other Postretirement Benefits	114,390			120,336			132,840			131,630
Derivative Instruments	2,124			4,067			6,687			2,629
Other	93,263			94,724			93,447			89,009
Total Regulatory and Other Liabilities	1,037,238			994,437			1,081,707			1,053,116

Commitments and Contingencies

Total Capitalization and Other Liabilities	$	4,416,809		$	4,249,478		$	4,486,653		$	4,449,989

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

(Concluded)

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 at December 31, 2014 $ 1,116,539
$ (6,357 ) $ 111,523
$ (5,926 ) $ 1,215,779
Net Income 115,794
115,794
Other Comprehensive Income, Net of Tax 1,089
1,089
Dividend Declared to Parent (25,000 ) (25,000 )
Contribution from Parent 180,000
180,000
Balances at September 30, 2015 $ 1,296,539
$ (6,357 ) $ 202,317
$ (4,837 ) $ 1,487,662



	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 Loss						(702		)				(702		)
Other Comprehensive Income, Net of Tax									65			65
Adoption of ASU, Cumulative Effect Adjustment						9,653						9,653
Balances as of March 31, 2016	$	1,296,539	$	(6,357	)	$	198,268		$	(4,499	)	$	1,483,951

Common Stock Capital Stock Expense Retained Earnings Accumulated Other Comprehensive Loss Total Stockholder's Equity
Balances at December 31, 2015 $ 1,296,539
$ (6,357 ) $ 189,317
$ (4,564 ) $ 1,474,935
Net Income 111,447
111,447
Other Comprehensive Income, Net of Tax 553
553
Dividend Declared to Parent (20,000 ) (20,000 )
Balances at September 30, 2016 $ 1,296,539
$ (6,357 ) $ 280,764
$ (4,011 ) $ 1,566,935



	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						20,759					20,759
Other Comprehensive Income, Net of Tax								189			189
Balances as of March 31, 2017	$	1,296,539	$	(6,357	)	$	294,167	$	(4,366	)	$	1,579,983

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

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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 ~~419,000~~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).

~~References in these notes to "we" and "our" are to TEP.~~

BASIS OF PRESENTATION

~~We prepared our~~TEP's condensed consolidated financial statements ~~according to~~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 ~~our~~its proportionate share of the operating costs associated with these facilities is included in the Condensed Consolidated Statements of Income. 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 ~~our 2015~~its 2016 Annual Report on Form 10-K.

The condensed consolidated financial statements are unaudited, but, in management's opinion, include all 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, ~~our~~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 income statement reflects a reclassification related to wholesale contracts. The Condensed Consolidated Income Statements reflect a reclassification between Wholesale Revenues and Purchased Power Expense of $2 million for the three months ended March 31, 2016. Management does not believe the reclassification is material to the previously issued financial statements.

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 March 31, 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 statement of income 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 statement and the statement of cash flows were not significant. TEP elected to recognize forfeitures when they occur.

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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 is not expected to have any impact on TEP as the Company recovers the cost of inventory in rates.

NOTE 2. REGULATORY MATTERS

The Arizona Corporation Commission (ACC) and the Federal Energy Regulatory Commission (FERC) each regulate portions of ~~the~~ 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.

~~2015~~2017 RATE ~~CASE~~ORDER

In ~~November 2015, TEP filed a general rate case with~~February 2017, the ACC ~~based on~~issued a ~~test year ended June 30, 2015 (2015~~rate order for new rates that took effect February 27, 2017 (2017 Rate ~~Case)~~Order).

~~Key provisions of TEP's general rate case include:~~

~~a non-fuel base rate increase of $110 million, or 12%, compared with adjusted test year revenues;~~

~~a 7.34% return on original cost rate base of $2.1 billion;~~

~~a request to apply excess depreciation reserves against the unrecovered net book value (NBV)~~Provisions of the ~~San Juan Generating Station (San Juan) Unit 2 and the coal handling facilities at the H. Wilson Sundt Generating Station (Sundt) due to early retirement;~~2017 Rate Order include, but are not limited to:

a request for authority to begin using the Third-Party Owners' portion of Springerville Generating Station (Springerville) Unit 1 that is available to TEP for dispatch to serve retail customers' needs and to recover the related operating costs through the Purchased Power and Fuel Adjustment Clause (PPFAC); and

rate design changes that would reduce the reliance on volumetric sales to recover fixed costs and a new net metering tariff that would ensure that customers who install distributed generation pay an equitable price for their electric service.

~~In August 2016, TEP, ACC Staff, and other parties to TEP's pending rate case proceeding entered into a partial settlement agreement regarding the revenue requirement. The settlement reflects~~ a non-fuel base rate increase of $81.5 million, ~~and a~~

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~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)~~

~~7.04% return on original cost rate base. The return on original cost rate base~~which includes ~~a cost of equity component of 9.75% and an average cost of debt component of 4.32%. The non-fuel base rate increase includes the recovery of approximately~~ $15 million of operating costs related to the 50.5% undivided interest in ~~Springerville~~ Unit 1 of Springerville Generating Station (Springerville) purchased by TEP in September ~~2016. Recovery~~2016;

a 7.04% return on original cost rate base, which includes a cost of ~~these costs had previously been requested through the PPFAC. In addition, the settlement agreement reflects the~~ equity component of 9.75% and a cost of debt component of 4.32%; and

adoption of TEP's proposed depreciation and amortization rates, ~~as well as~~which include a reduction in the depreciable life for Unit 1 of San Juan ~~Unit 1.~~ Generating Station (San Juan).

The ~~settlement agreement requires the approval of the~~ ACC ~~before new rates can become effective.~~

Hearings before an Administrative Law Judge (ALJ) were held in September 2016, and a Recommended Opinion and Order (ROO) is expected in the fourth quarter of 2016. TEP requested new rates to be implemented by January 1, 2017.

~~Issues~~deferred matters related to net metering and rate design for new distributed generation (DG) customers ~~have been deferred~~ to a second phase of ~~this~~TEP’s rate case ~~proceeding,~~proceedings (Phase 2), which is expected to ~~begin in the first quarter~~be completed by end of 2017.

TEP cannot predict the outcome of ~~this proceeding or whether its rate request will be adopted by the ACC in whole or in part.~~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 ~~PPFAC~~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 ~~Retail Rates;~~rates designed to allow a regulated utility to recover 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 $31 million as of March 31, 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 ~~March~~February 2017⁽¹⁾	0.15
April 2015 through April 2016	0.68
~~October 2014 through March 2015~~ ⁽²⁾	~~0.50~~


⁽¹⁾	~~In April 2016, the ACC approved the PPFAC rate adjustment effective May 2016.~~


⁽²⁾	~~The ACC approved a new rate effective October 2014.~~

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 ~~distributed generation~~DG accounting for 30%

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

of the annual renewable energy requirement. Arizona utilities must file an annual RES implementation plan for review and approval by the ACC.

In ~~May 2016,~~March 2017, the ACC approved TEP's ~~2016~~2017 RES implementation plan ~~that included a budget~~ of ~~$57~~$54 million, which was partially offset by applying approximately $9$2 million of previously recovered carryover funds. TEP ~~will~~has been approved to recover the remaining ~~$48~~$52 million through the RES surcharge. The ~~budget will fund~~recovery funds the following: (i) the above market cost of renewable ~~energy~~power purchases; (ii) previously awarded performance-based incentives for customer installed ~~distributed generation;~~DG; (iii) depreciation and a return on ~~certain investments in~~a company-owned solar ~~projects;~~project; and (iv) various other program costs.

TEP expects to recover less than $1 million of revenue in 2017 through the RES surcharge as a return on company-owned solar projects. This amount reflects the return and related recovery on projects that are not included in TEP’s Retail Rates. TEP suspended its rooftop solar program effective December 2016, but requested approval of a community solar program. The ACC ~~will consider TEP's rooftop solar and community solar programs in the second phase of the 2015 Rate Case, which~~ is expected to ~~begin~~consider this program in ~~the first quarter~~Phase 2 of ~~2017.~~TEP's rate case.

The percentage of retail kilowatt-hour (kWh) sales attributable to the ~~2015~~2016 RES renewable energy requirement was ~~8.6%~~10%, which exceeded the overall ~~2015 requirement of 5.0%. TEP expects to meet the~~ 2016 requirement of ~~6.0% of retail kWh sales.~~6%. Compliance is determined through the ACC's review of TEP's annual RES implementation plan. As TEP no longer pays incentives to obtain ~~distributed generation~~DG renewable energy credits, which are used to demonstrate compliance with the ~~distributed generation~~DG requirement, the ACC approved a waiver of the 2016 and 2017 residential ~~distributed generation~~DG requirement.

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~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)~~

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 for a DSM surcharge for regulated utilities to recover from retail customers the costs to implement DSM programs 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 ~~2016~~2017 and $3$2 million in ~~2015.~~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. Under~~plan which included a budget of approximately $22 million to be funded in part with an over-collected DSM bank balance of $8 million and a DSM surcharge designed to collect the ~~2016 plan, TEP will recover approximately~~remaining $14 million from retail ~~customers for new and existing DSM programs.~~customers. 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.

TEP notified the ACC that it would not file a 2017 implementation plan and will continue its 2016 plan through the end of 2017 without a change to the previously approved energy efficiency programs or budget. In order to fund the approved implementation plan budget during 2017, in March 2017, TEP filed an application with the ACC to increase the DSM surcharge by approximately $7 million. TEP cannot predict if or when the ACC will consider its application. TEP plans to file its 2018 implementation plan in June 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 meeting ~~distributed generation~~DG targets. 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 1%2% of TEP's applicable retail revenues.

TEP recorded a regulatory asset and recognized LFCR revenues of $5$6 million and ~~$14~~$5 million in the three ~~and nine~~ months ended ~~September 30,~~March 31, 2017 and 2016, ~~respectively. TEP recorded $3 million and $9 million in the three and nine months ended September 30, 2015,~~ respectively. LFCR revenues are included in Retail Revenues on the Condensed Consolidated Statements of Income.

~~Appellate Review of Rate Decisions~~

In a 2015 appellate challenge to two ACC rate decisions regarding a water company, the Arizona Court of Appeals considered the issue of how the ACC should determine a utility’s “fair value,” as specified in the Arizona Constitution, in connection with authorizing recovery of costs through rate adjustors outside of a rate case. The Court reversed the ACC’s method of finding fair value in that case and raised questions concerning the relationship between the need for fair value findings and the recovery of capital and certain other utility costs through adjustors. In February 2016, the Arizona Supreme Court granted the ACC’s request for review of this decision. In August 2016, the Supreme Court vacated the Court of Appeals decision and confirmed the ACC’s decision regarding the rate adjustor at issue.

FERC COMPLIANCE

In ~~April and October~~ 2016, the FERC issued orders relating to certain late-filed transmission service agreements (TSAs), which resulted in TEP ~~accruing~~recording a ~~total of $22 million in time value~~liability and paying time-value refunds ~~payable~~ to the ~~counterparties.~~counterparties of these TSAs. See Note 6 for additional information related to FERC compliance associated with these transmission contracts.

REGULATORY ASSETS AND LIABILITIES

Regulatory assets are either being collected or are expected to be collected through Retail Rates. With the exception of the leasehold improvements at Springerville Unit 1 and the coal handling facilities at Sundt, ~~we do~~TEP does not earn a return on regulatory assets. Regulatory liabilities represent items that we either expect to pay to customers through billing reductions in future periods or plan to use for the purpose for which they were collected from customers. With the exception of over-recovered PPFAC costs, TEP does not pay or accrue a return on regulatory liabilities.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

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. The regulatory assets and liabilities recorded in the ~~Condensed Consolidated Balance Sheets~~balance sheet are summarized in the table below:


(in millions)	Remaining Recovery Period (years)	September 30, 2016		December 31, 2015
(dollars in millions)						Remaining Recovery Period (years)	March 31, 2017		December 31, 2016
Regulatory Assets
Pension and Other Postretirement Benefits	Various	$	115	$	120
Pension and Other Postretirement Benefits (Note 7)						Various	$	126	$	128
Final Mine Reclamation and Retiree Health Care Costs ⁽¹⁾	21	30		28		20	29		27
Income Taxes Recoverable through Future Rates	Various	28		26		Various	29		29
Lost Fixed Cost Recovery						1	27		23
Property Tax Deferrals	1	23		21		1	23		23
Lost Fixed Cost Recovery	1	21		16
Springerville Unit 1 Leasehold Improvements⁽²⁾	7	18		21		6	15		17
Sundt Coal Handling Facilities ⁽³⁾	Plant Life	16		—		N/A	—		14
Derivatives (Note 9)	3	2		12
Other Regulatory Assets	Various	18		20		Various	32		20
Total Regulatory Assets		271		264			281		281
Less Current Portion	1	53		52		1	60		56
Total Non-Current Regulatory Assets		$	218	$	212		$	221	$	225


Regulatory Liabilities
Net Cost of Removal for Interim Retirements ⁽⁴⁾	Various	$	266	$	264	Various	$	280	$	270
Renewable Energy Standard						Various	34		32
Purchased Power and Fuel Adjustment Clause	1	38		18		1	31		38
Renewable Energy Standard	Various	29		25
Deferred Investment Tax Credits	Various	28		32		Various	23		23
Other Regulatory Liabilities	Various	19		21		Various	10		14
Total Regulatory Liabilities		380		360			378		377
Less Current Portion	1	77		53		1	69		76
Total Non-Current Regulatory Liabilities		$	303	$	307		$	309	$	301

⁽¹⁾

Final Mine Reclamation and Retiree Health Care Costs ~~are recognized~~represents costs associated with TEP’s jointly-owned facilities at San Juan, Four Corners Generating Station (Four Corners), and Navajo Generating Station (Navajo). TEP recognizes these costs at future ~~value. TEP will~~value and is permitted to fully recover these costs through the PPFAC ~~when paid.~~mechanism. The majority of ~~our~~ final mine reclamation costs are expected to occur through 2037.


⁽²⁾	Springerville Unit 1 Leasehold Improvements represent investments TEP made, which were previously recorded in Plant in Service on the Condensed Consolidated Balance Sheets, 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.

⁽³⁾

In ~~June 2014,~~March 2016, TEP notified the Environmental Protection Agency (EPA) issued a final rule that required TEP to either: (i) install, by mid-2017, Selective Non-Catalytic Reduction (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-Best Available Retrofit Technology (BART) alternative by the end of 2017. In March 2016, TEP notified the EPA of its decision to permanently eliminate coal as a fuel source, and transferred the ~~NBV~~net book value (NBV) of the Sundt Coal Handling Facilities to a regulatory asset. ~~Consistent with the 2013 Rate Order,~~The ACC authorized TEP ~~has requested authorization from the ACC~~ to apply excess depreciation reserves against the unrecovered NBV in ~~its 2015~~the 2017 Rate ~~Case.~~Order. As a result, TEP transferred $14 million from Regulatory Assets to Accumulated Depreciation on the Condensed Consolidated Balance Sheets.


⁽⁴⁾	Net Cost of Removal for Interim Retirements represents an estimate of the cost of future asset retirement obligations (ARO) net of salvage value. These are amounts collected through revenue for the net cost of removal of interim retirements for transmission, distribution, generation plant, and general and intangible plant which are not yet expended.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 3.ACCOUNTS RECEIVABLE

The following table presents the components of Accounts Receivable, Net on the Condensed Consolidated Balance Sheets:


(in millions)	September 30, 2016			December 31, 2015			March 31, 2017			December 31, 2016
Customer	$	103		$	79		$	66		$	74
Due from Affiliates (Note 4)	6			7			5			9
Unbilled	41			39			30			34
Other⁽¹⁾	10			39			13			13
Allowance for Doubtful Accounts⁽¹⁾	(4		)	(27		)	(5		)	(5		)
Accounts Receivable, Net	$	156		$	137		$	109		$	125


⁽¹⁾	~~In September 2016, Accounts Receivable~~ – Other and Allowance for Doubtful Accounts decreased due to the settlement and release of asserted claims between TEP and the Third-Party Owners related to Springerville Unit 1. See Note 6 for additional information regarding the settlement of the Third-Party Owners' claims.

NOTE 4. RELATED PARTY TRANSACTIONS

TEP engages in various transactions with Fortis, UNS Energy, and its affiliated subsidiaries including ~~UniSource Energy Services, Inc. (UES),~~ 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) September 30, 2016 December 31, 2015
Receivables from Related Parties
UNS Electric $ 5
$ 6
UNS Gas 1
1
Total Due from Related Parties $ 6
$ 7

Payables to Related Parties
SES $ 1
$ 2
UNS Energy 1
2
UNS Electric —
2
Total Due to Related Parties $ 2
$ 6

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~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)~~



(in millions)	March 31, 2017		December 31, 2016
Receivables from Related Parties
UNS Electric	$	4	$	7
UNS Gas	1		2
Total Due from Related Parties	$	5	$	9

Payables to Related Parties
SES	$	2	$	2
UNS Energy	1		—
Total Due to Related Parties	$	3	$	2

The following table presents the related party transactions included in the ~~Condensed Consolidated Statements of Income:~~income statement:

Three Months Ended September 30, Nine Months Ended September 30,
(in millions) 2016 2015 2016 2015
Goods and Services Provided by TEP to Affiliates

Transmission Revenues - UNS Electric ⁽¹⁾
$ 2
$ 2
$ 5
$ 4
Wholesale Revenues - UNS Electric ⁽¹⁾
—
—
—
1
Control Area Services - UNS Electric ⁽²⁾
1
1
2
1
Common Costs - UNS Energy Affiliates ⁽³⁾
3
3
10
9

Goods and Services Provided by Affiliates to TEP
Wholesale Revenues - UNS Electric ⁽¹⁾
$ —
$ —
$ —
$ 1
Supplemental Workforce - SES ⁽⁴⁾
3
4
10
13
Corporate Services - UNS Energy ⁽⁵⁾
1
1
5
3
Corporate Services - UNS Energy Affiliates ⁽⁶⁾
1
—
3
1



	Three Months Ended March 31,
(in millions)	2017		2016
Goods and Services Provided by TEP to Affiliates
Transmission Revenues, UNS Electric ⁽¹⁾	$	1	$	1
Control Area Services, UNS Electric ⁽²⁾	1		—
Common Costs, UNS Energy Affiliates ⁽³⁾	4		3

Goods and Services Provided by Affiliates to TEP
Supplemental Workforce, SES ⁽⁴⁾	3		4
Corporate Services, UNS Energy ⁽⁵⁾	1		2
Corporate Services, UNS Energy Affiliates ⁽⁶⁾	1		—


⁽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~~Control Area Services under a FERC-approved Control Area Services Agreement.


⁽³⁾	Common ~~costs~~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.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)


⁽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~~Corporate Services at UNS Energy ~~include Fortis management fees, legal fees, and audit fees which~~ 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. ~~For the three~~Corporate Services, UNS Energy includes legal, audit, and ~~nine months ended September 30, 2016, these costs included approximately $1 million and $4 million, respectively, in~~ Fortis management fees. For the three ~~and nine~~ months ended ~~September 30, 2015,~~March 31, 2017 and 2016, these costs included Fortis management fees ~~were~~of $1 ~~million and $3 million, respectively.~~million.


⁽⁶⁾	Costs for ~~corporate services~~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 months ended March 31, 2017 or 2016.

DIVIDENDS PAID TO PARENT

TEP ~~declared and paid a $20 million dividend~~did not declare or pay dividends to UNS Energy in the ~~first nine~~three months ~~of 2016 and a $25 million dividend in the first nine months of 2015.~~ended March 31, 2017 or 2016.

NOTE 5. DEBT, CREDIT FACILITY, AND CAPITAL LEASE OBLIGATIONS

There have been no significant changes to ~~our~~TEP's debt, credit facility, or capital lease obligations from those reported in ~~our 2015~~its 2016 Annual Report on Form 10-K, except as noted below.

~~CREDIT FACILITY~~

~~TEP's revolving credit facility provides for~~As of March 31, 2017, there was $250 million ofavailable under the revolving credit commitments ~~with a~~and LOC ~~sublimit~~facilities. As of ~~$50~~May 1, 2017, TEP had $235 million ~~through~~available under its ~~original October 2020 maturity. In October 2016, TEP extended the agreement one year to October 2021 as permitted by the~~revolving credit ~~agreement. The credit facility~~ commitments ~~will be reduced to $217.5 million in the final year of the agreement.~~

~~CAPITAL LEASE OBLIGATIONS~~

~~Springerville Coal Handling Facilities~~

In April 2015, upon the expiration of the lease term, TEP purchased an undivided ownership interest in the coal handling facilities at Springerville used by all four Springerville units (Springerville Coal Handling Facilities). With the completion of

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~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)~~

~~this purchase, Tri-State Generation~~ and Transmission Association, Inc. (Tri-State) was obligated to either: (i) buy a 17.05% undivided interest in the facilities for approximately $24 million; or (ii) continue to make payments to TEP for the use of theLOC facilities. In March 2016, Tri-State notified TEP that it was exercising its option to purchase the undivided interest in the facilities. The Tri-State purchase is expected to close by the end of 2016. At September 30, 2016, the 17.05% undivided interest in the Springerville Coal Handling Facilities that Tri-State plans to purchase is classified as Assets Held for Sale on the Condensed Consolidated Balance Sheets.

COVENANT COMPLIANCE

~~At September 30, 2016, we were~~As of March 31, 2017, TEP was in compliance with the terms of ~~our~~its credit and long-term debt agreements.

NOTE 6. COMMITMENTS AND CONTINGENCIES

COMMITMENTS

~~In addition~~There have been no significant changes to TEP's long-term commitments from those reported in ~~our 2015~~its 2016 Annual Report on Form ~~10-K, TEP entered into the following long-term commitments through September 30, 2016:~~

(in millions) 2016 2017 2018 2019 2020 Thereafter Total
Fuel, Including Transportation $ 21
$ 26
$ 27
$ 27
$ 26
$ 26
$ 153
Transmission 2
4
4
4
4
3
21
Renewable Power Purchase Agreements 3
3
3
3
3
43
58
Total Purchase Commitments $ 26
$ 33
$ 34
$ 34
$ 33
$ 72
$ 232

TEP's transmission and fuel costs, including transportation, are recoverable from customers through the PPFAC mechanism. A portion of the cost of renewable energy is recoverable through the PPFAC, with the balance of costs recoverable through the RES tariff. See Note 2 for information on ACC approved cost recovery mechanisms.

~~Fuel, Including Transportation~~

TEP has long-term contracts for the purchase and delivery of coal with various expiration dates through 2031. Amounts paid under these contracts depend on actual quantities purchased and delivered. Some of these contracts include price adjustment components that will affect the future cost.

In January 2016, the existing coal supply agreement for San Juan terminated and a new Coal Supply Agreement (CSA) became effective. The new CSA is between San Juan Coal Company (SJCC) and Public Service Company of New Mexico (PNM) and continues through June 2022. TEP is not a party to the new CSA, but has minimum purchase obligations under restructured ownership agreements at San Juan.

In April 2016, Peabody Energy Corp. (Peabody) filed for reorganization under Chapter 11 of the Bankruptcy Code. TEP has existing contracts with Peabody to supply coal from the El Segundo and Lee Ranch mines to Springerville and from the Kayenta mine to the Navajo Generating Station (Navajo). TEP has continued to receive its contracted coal as planned and has sufficient access to coal inventory for the near future. TEP cannot currently predict the outcome of this matter or the range of its potential impact on TEP's coal supply from Peabody.

~~In September 2016, TEP extended the expiration date of one of its long-term pipeline transportation contracts from March 2017 to March 2022.~~

~~Transmission~~

TEP has agreements with other utilities to purchase transmission services over lines that are part of the Western Interconnection, a regional grid in the United States. These contracts expire in various years between 2017 and 2028.

~~In June 2016, TEP entered into a new firm point-to-point transmission service agreement. The service agreement has a start date of August 2016 and expires in July 2021.~~

~~Renewable Power Purchase Agreements~~

TEP enters into long-term renewable Power Purchase Agreements (PPA) which require TEP to purchase 100% of certain renewable energy generation facilities output once commercial operation status is achieved. In March 2016, one of these

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~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)~~

facilities achieved commercial operation. The PPA expires in February 2036. While TEP is not required to make payments under the agreement if power is not delivered, estimated future payments are included in the table above.

TEP's long-term renewable PPAs effectively transfer commodity price risk to TEP 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 Variable Interest Entities (VIEs). TEP reconsiders whether it is a primary beneficiary of the VIEs on a quarterly basis.

At September 30, 2016, the carrying amount of assets and liabilities in our Condensed Consolidated Balance Sheets that relate to our variable interests under long-term PPAs are predominantly related to working capital accounts and generally represent the amounts owed by TEP for the deliveries associated with the current billing cycle. Our maximum exposure to loss is limited to the cost of replacing the power if the providers do not meet the production guarantee. However, our exposure is mitigated as we would likely recover these costs through cost recovery mechanisms.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 ~~does not believe that~~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 ~~described~~disclosed below.

Claims Related to ~~Springerville~~Four Corners Generating Station ~~Unit 1~~

~~In February~~Endangered Species Act

On April 20, 2016, ~~TEP entered into an agreement with~~several environmental groups filed a lawsuit in the ~~Third-Party Owners~~U.S. District Court for the ~~settlement~~District of Arizona against the Office of Surface Mining (OSM) and ~~release~~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 ~~asserted claims~~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 ~~purchase~~adjacent Navajo Mine. In addition, the lawsuit alleges that these federal agencies violated both the ESA and ~~sale~~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 ~~beneficial interests in Springerville Unit 1 (Agreement). The Agreement provided that: (i) TEP would purchase~~relief, including a finding that the ~~Third-Party Owners’ 50.5% undivided interest in Springerville Unit 1 for $85 million;~~federal defendants violated the ESA and ~~(ii)~~ the ~~Third-Party Owners would pay TEP $12.5 million for operating costs related to Springerville Unit 1 incurred on behalf~~NEPA

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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 ~~Third-Party Owners.~~

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. Briefing on the merits is expected to extend through May 2017. 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. TEP ~~received FERC authorization to complete~~cannot currently predict the ~~transactions contemplated in~~outcome of this matter or the Agreement. In accordance with the Agreement, TEP purchased the undivided interest in Springerville Unit 1 for $85 million. The purchase increased TEP's total ownership interest to 100%. As also provided for in the Agreement, TEP received $12.5 million from the Third-Party Owners in full satisfactionrange of all previously unreimbursed operating costs, which TEP recorded in Operating Revenues – Other on the Condensed Consolidated Statements of Income. Following the purchase, all outstanding disputes, pending litigation, and arbitration proceedings between TEP and the Third-Party Owners were dismissed with prejudice.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 ~~Office of Surface Mining (OSM)~~OSM challenging federal administrative decisions ~~affecting seven different mines in four states~~ 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 ~~fifteen~~ claims for relief in the WEG Petition, two concern ~~SJCC’s~~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 ~~National Environmental Policy Act (NEPA)~~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 ~~seven~~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. OnIn August ~~31,~~ 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 by August 31, 2019, then an

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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.

~~Bureau of Land Management~~

In August 2013, the Bureau of Land Management (BLM) proposed regulations that, among other things, redefine the term “underground mine” to exclude high-wall mining operations and impose a higher surface mine coal royalty on high-wall mining. SJCC utilized high-wall mining techniques at its surface mines prior to beginning underground mining operations in January 2003. If the proposed regulations become effective, SJCC may be subject to additional royalties on coal delivered to San Juan between August 2000 and January 2003 totaling approximately $5 million of which TEP’s proportionate share would be approximately $1 million. TEP owns 50% of Units 1 and 2 at San Juan, which represents approximately 20% of the total generation capacity at San Juan, and is responsible for its share of any settlements. TEP cannot predict the final outcome of the BLM’s proposed regulations.

~~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 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 (DOI) 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 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 the 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. TEP cannot currently predict the outcome of this matter or the range of its potential impact.

~~Navajo Generating Station Lease Amendment~~

Navajo is located on a site that is leased from the Navajo Nation with an initial lease term through 2019. The Navajo Nation signed a lease amendment in 2013 that would extend the lease from 2019 through 2044. The participants in Navajo, including TEP, have not signed the lease amendment because certain participants have expressed an interest in discontinuing their participation in Navajo. Negotiations between the participants are ongoing, and all parties will likely agree to the terms. To become effective, this lease amendment must be signed by all of the participants, approved by the DOI, and is subject to environmental reviews. Once the lease amendment becomes effective, the participants will be responsible for additional lease costs from the date the Navajo Nation signed the lease amendment. TEP owns 7.5% of Navajo. In the three and nine months ended September 30, 2016, TEP recorded additional estimated lease expense of less than $1 million and $1 million, respectively, with the expectation that the lease amendment will become effective. TEP's Condensed Consolidated Balance Sheets reflect a total lease amendment liability recorded in Regulatory and Other Liabilities—Other of $4 million at September 30, 2016 and $3 million at December 31, 2015.

Mine Reclamation at Generating ~~Stations~~Facilities Not Operated by TEP

TEP pays ongoing reclamation mine costs related to coal mines that supply ~~generating stations~~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 ~~$42~~$61 million upon expiration of the coal supply agreements, which expire between 2019 and 2031. ~~TEP's Condensed Consolidated Balance Sheets reflect~~The balance sheet reflected a total liability related to reclamation of ~~$24~~$27 million ~~at September 30, 2016~~as of March 31, 2017 and ~~$25~~$26 million atas of December 31, ~~2015.~~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.

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~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)~~

TEP’s PPFAC allows usthe 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.

~~Gila River Emissions Compliance~~

In August 2016, Gila River Generating Station (Gila River) received a Notice of Violation from the Maricopa County Air Quality Department (MCAQD) stating the facility failed to monitor emissions during startup and to properly calibrate carbon monoxide monitors. TEP owns 75% of Gila River Unit 3. Gila River has already performed the necessary corrective actions to address the alleged violations. TEP will continue to work with the other participants at Gila River to address the notice. A response from Gila River to MCAQD was submitted in August 2016. TEP cannot currently predict the outcome of this matter or the range of potential loss or fines, if any.

FERC Compliance

In 2015 and 2016, TEP self-reported to the FERC Office of Enforcement (OE) that ~~TEP~~the Company had not timely filed certain FERC-jurisdictional agreements. ~~At that time,~~ TEP conducted a comprehensive internal ~~review~~reviews of its compliance with the FERC filing requirements (Compliance ~~Review),~~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 ~~form of~~ service ~~agreement. The results~~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 ~~Compliance Review were reported~~FERC Refund Orders and ongoing discussions with the

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

OE, in 2016 TEP recorded $22 million in time-value refunds offsetting Wholesale Revenues on the Condensed Consolidated Statements of Income, and, of the amount accrued, paid out $17 million in time-value refunds to the ~~OE,~~counterparties.

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. Under the agreement, the counterparty paid TEP $8 million in January 2017, which isTEP recorded in Other Income on the Condensed Consolidated Statements of Income, and TEP dismissed the appeal with prejudice.

The Condensed Consolidated Balance Sheets reflected $5 million as of March 31, 2017 and December 31, 2016, accrued in Current Liabilities—Other. TEP's Compliance Reviews are still ~~reviewing~~under review by the ~~matter.~~OE. The FERC could impose civil penalties on TEP as a result of the OE's review of the Compliance ~~Review.~~

In April 2016, the FERC issued an order relating to the late-filed TSAs, which directed TEP to issue time value refunds to the counterparties to these TSAs (FERC Refund Order). As a result, TEP accrued $13 million in March 2016 offsetting Wholesale Revenues on the Condensed Consolidated Statements of Income. As authorized in the FERC Refund Order, TEP reviewed its refund calculations including losses incurred as a result of the calculated refunds and determined the refund amount to be $3 million. TEP filed a refund report including the updated calculations with the FERC in July 2016.

In October 2016, in response to TEP's filed refund report, the FERC issued an additional order (October 2016 FERC Order) which: (i) rejected the filed refund report; (ii) directed TEP to recalculate and pay additional time value refunds within 30 days; and (iii) file a revised refund report with the FERC within 30 days thereafter. TEP has the right to seek a rehearing of the October 2016 FERC Order within 30 days of issuance. As a result of the October 2016 FERC Refund Order and ongoing discussions with the OE, TEP accrued an additional $9 million in September 2016, which offsets Wholesale Revenues on the Condensed Consolidated Statements of Income. TEP paid time value refunds of $3 million in the first nine months of 2016 and an additional $14 million in October 2016.

In June 2016, to preserve its rights, TEP petitioned the D.C. Circuit Court of Appeals to review the FERC Refund Order. In July 2016, TEP filed an unopposed motion to suspend the appeal, which the Court has since granted. As a result of the October 2016 FERC Order, TEP intends to pursue the appeal.Reviews. At this time, TEP cannot predict the outcome ~~of these matters~~ or ~~the~~ range of ~~possible recoveries or~~ additional losses, if any.

Performance Guarantees

TEP has joint participation agreements with participants at Navajo, San Juan, Four Corners, and with Luna ~~Energy Facility~~Generating Station (Luna). The participants in each of the ~~generating stations,~~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 ~~generating~~generation capacity of the defaulting participant. ~~At September 30, 2016,~~With the exception of Four Corners, there is no maximum potential amount of future payments (undiscounted) TEP could be required to make under the guarantees. The maximum potential amount of future payments is $250 million at Four Corners. As of March 31, 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.

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 all applicable environmental laws and regulations.

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~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)~~

NOTE 7. EMPLOYEE BENEFIT PLANS

Net periodic benefit cost includes the following components:

Pension Benefits Other Postretirement Benefits
Three Months Ended September 30,
(in millions) 2016 2015 2016 2015
Service Cost $ 3
$ 3
$ 1
$ 1
Interest Cost 4
5
1
—
Expected Return on Plan Assets (5 ) (6 ) —
—
Amortization of Net Loss 1
2
—
—
Net Periodic Benefit Cost $ 3
$ 4
$ 2
$ 1

Nine Months Ended September 30,
(in millions) 2016 2015 2016 2015
Service Cost $ 9
$ 9
$ 3
$ 3
Interest Cost 11
13
2
2
Expected Return on Plan Assets (17 ) (18 ) (1 ) (1 )
Amortization of Net Loss 5
6
—
—
Net Periodic Benefit Cost $ 8
$ 10
$ 4
$ 4

~~CONTRIBUTIONS~~

~~TEP made contributions to the pension plans of $8 million during the nine months ended September 30, 2016. No additional contributions are planned in 2016.~~



	Pension Benefits						Other Postretirement Benefits
	Three Months Ended March 31,
(in millions)	2017			2016			2017		2016
Service Cost	$	3		$	3		$	1	$	1
Interest Cost	4			4			—		—
Expected Return on Plan Assets	(6		)	(6		)	—		—
Amortization of Net Loss	2			2			—		—
Net Periodic Benefit Cost	$	3		$	3		$	1	$	1

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

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:


	Nine Months Ended September 30,					Three Months Ended March 31,
(in millions)	2016		2015			2017		2016
Accrued Capital Expenditures	$	16	$	21		$	19	$	14
Net Cost of Removal of Interim Retirements ⁽¹⁾	3		(2		)
Additions to Utility Plant, Springerville Unit 1 Settlement	5		—
Net Cost of Removal ⁽¹⁾						10		3


⁽¹⁾	~~The non-cash net cost~~Non-cash Net Cost of ~~removal of interim retirements~~Removal represents an accrual for future AROs that does not impact earnings.

NOTE 9. FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS

~~We categorize our~~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 recordedat the end of a reporting period. There were no transfers between levels in the periods presented.

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~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)~~

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) September 30, 2016
Assets
Cash Equivalents⁽¹⁾
$ 40
$ —
$ —
$ 40
Restricted Cash⁽¹⁾
4
—
—
4
Energy Derivative Contracts, Regulatory Recovery⁽²⁾
—
1
—
1
Energy Derivative Contracts, No Regulatory Recovery⁽²⁾
—
—
3
3
Total Assets 44
1
3
48
Liabilities
Energy Derivative Contracts, Regulatory Recovery⁽²⁾
—
(3 ) —
(3 )
Interest Rate Swap⁽³⁾
—
(2 ) —
(2 )
Total Liabilities —
(5 ) —
(5 )
Net Total Assets (Liabilities) $ 44
$ (4 ) $ 3
$ 43


												Level 1		Level 2			Level 3			Total
(in millions)	December 31, 2015											March 31, 2017
Assets
Cash Equivalents⁽¹⁾	$	33	$	—		$	—		$	33		$	22	$	—		$	—		$	22
Restricted Cash⁽¹⁾	4		—			—			4			7		—			—			7
Energy Derivative Contracts, Regulatory Recovery⁽²⁾	—		1			—			1			—		2			1			3
Energy Derivative Contracts, No Regulatory Recovery⁽²⁾	—		—			1			1			—		—			1			1
Total Assets	37		1			1			39			29		2			2			33
Liabilities
Energy Derivative Contracts, Regulatory Recovery⁽²⁾	—		(10		)	(3		)	(13		)	—		(7		)	(1		)	(8		)
Interest Rate Swap⁽³⁾	—		(3		)	—			(3		)	—		(2		)	—			(2		)
Total Liabilities	—		(13		)	(3		)	(16		)	—		(9		)	(1		)	(10		)
Net Total Assets (Liabilities)	$	37	$	(12	)	$	(2	)	$	23
Total Assets (Liabilities), Net												$	29	$	(7	)	$	1		$	23

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)



(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 on the Condensed Consolidated Balance Sheets.


⁽²⁾	Energy Contracts include gas swap agreements (Level 2), ~~gas options (Level 3),~~ and forward purchased power ~~purchase~~ 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 ~~LIBOR~~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. ~~We present~~TEP presents derivatives on a gross basis in the ~~Condensed Consolidated Balance Sheets.~~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			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								Counterparty Netting of Energy Contracts			Cash Collateral Received/Posted
(in millions)	September 30, 2016											March 31, 2017
Derivative Assets
Energy Derivative Contracts	$	4		$	1		$	—	$	3		$	4		$	3		$	—	$	1
Derivative Liabilities
Energy Derivative Contracts	(3		)	(1		)	—		(2		)	(8		)	(3		)	—		(5		)
Interest Rate Swap	(2		)	—			—		(2		)	(2		)	—			—		(2		)


(in millions)	December 31, 2015											December 31, 2016
Derivative Assets
Energy Derivative Contracts	$	2		$	1		$	—	$	1		$	5		$	2		$	—	$	3
Derivative Liabilities
Energy Derivative Contracts	(13		)	(1		)	—		(12		)	(3		)	(2		)	—		(1		)
Interest Rate Swap	(3		)	—			—		(3		)	(2		)	—			—		(2		)

DERIVATIVE INSTRUMENTS

~~We enter~~TEP enters into various derivative and non-derivative contracts to reduce ~~our~~ exposure to energy price risk associated with ~~our~~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.~~PPFAC mechanism.

WeThe Company primarily ~~apply~~applies the market approach for recurring fair value measurements. When ~~we have~~TEP has observable inputs for substantially the full term of the asset or liability or ~~use~~uses quoted prices in an inactive market, ~~we categorize~~it categorizes the instrument in Level 2. ~~We categorize~~TEP categorizes derivatives in Level 3 when ~~we use~~ an aggregate pricing service or published prices that represent a consensus reporting of multiple ~~brokers.~~brokers is used.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For both power and natural gas prices, ~~we obtain~~TEP obtains quotes from brokers, major market participants, exchanges, or industry publications and ~~rely~~relies on ~~our~~its own price experience from active transactions in the market. WeThe Company primarily ~~use~~uses one set of quotations each for power and natural gas and then ~~validate~~validates those prices using other sources. ~~We believe~~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, ~~we apply~~TEP applies adjustments based on historical price curve relationships, transmission, and line losses.

~~We estimate the fair value of our gas options using a Black-Scholes-Merton option pricing model which includes inputs such as implied volatility, interest rates, and forward price curves.~~

WeTEP also ~~consider~~considers the impact of counterparty credit risk using current and historical default and recovery rates, as well as ~~our~~its own credit risk using credit default swap data.

The inputs and ~~our~~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. ~~We review~~TEP reviews the assumptions underlying ~~our~~its price curves monthly.

Cash Flow Hedges

~~We can enter into interest rate swaps to~~To mitigate the exposure to volatility in variable interest rates on ~~debt. We have~~debt, TEP has an interest rate swap agreement that expires January 2020. ~~We also had a power purchase swap to hedge the cash flow risk associated with a long-term power supply agreement which expired in September 2015.~~ 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)~~

~~Realized~~ The realized losses from ~~our~~its cash flow hedges are ~~shown in~~less than $1 million for the ~~following table:~~

three months ended March 31, 2017 and 2016, respectively.

Three Months Ended September 30, Nine Months Ended September 30,
(in millions) 2016 2015 2016 2015
Capital Lease Interest Expense $ —
$ —
$ 1
$ 1
Purchased Power —
1
—
1

~~At September 30, 2016,~~As of March 31, 2017, the total notional amount of ~~our~~the interest rate swap was ~~$23~~$18 million.

Energy Derivative Contracts - Regulatory Recovery

~~We record~~TEP records unrealized gains and losses on energy purchase contracts that are recoverable through the PPFAC inmechanism 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 September 30,				Nine Months Ended September 30,				Three Months Ended March 31,
(in millions)	2016		2015		2016		2015		2017			2016
Unrealized Net Gain (Loss) Recorded to Regulatory (Assets) Liabilities	$	1	$	4	$	10	$	7	$	(5	)	$	(2	)

Energy Derivative Contracts - No Regulatory Recovery

Forward contracts with long-term wholesale customers do not qualify for regulatory recovery. For ~~these~~ contracts that qualify as derivatives, ~~we record~~TEP records unrealized gains and losses in the income statement unless, and until, a normal purchase or normal sale election is made. The unrealized gains and losses on long-term power trading contracts are recorded in the income statement, and 10% of any gains will be shared with ratepayers through the PPFAC, as realized.

Derivative Volumes

~~At September 30, 2016, we have~~As of March 31, 2017, TEP had energy contracts that will settle through ~~2019.~~2020. The volumes associated with ~~our~~the energy contracts were as follows:


	September 30, 2016	December 31, 2015	March 31, 2017	December 31, 2016
Power Contracts GWh	3,076	1,752	1,846	2,610
Gas Contracts BBtu	10,769	17,214	21,832	12,355

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Level 3 Fair Value Measurements

The following ~~table provides~~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				Valuation Approach	Fair Value of						Range of Unobservable Input
	Valuation Approach	Assets		Liabilities		Unobservable Inputs	Range of Unobservable Input				Valuation Approach	Assets		Liabilities			Unobservable Inputs	Range of Unobservable Input
(in millions)	September 30, 2016										March 31, 2017
Forward Power Contracts	Market approach	$	3	$	—	Market price per MWh	$	19.10	$	37.40	Market approach	$	2	$	(1	)	Market price per MWh	$	12.15	$	36.80

Level 3 Energy Contracts		$	3	$	—


(in millions)	December 31, 2015													December 31, 2016
Forward Power Contracts	Market approach	$	1	$	(2	)	Market price per MWh	$	19.20		$	31.35		Market approach	$	2	$	(1	)	Market price per MWh	$	20.90	$	40.00

Gas Option Contracts	Option model	—		(1		)	Market price per MMBtu	$	2.17		$	2.69
							Gas volatility	31.0		%	58.3		%
Level 3 Energy Contracts		$	1	$	(3	)

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

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~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)~~

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.

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:


	Three Months Ended September 30,						Nine Months Ended September 30,						Three Months Ended March 31,
(in millions)	2016			2015			2016			2015			2017			2016
Beginning of Period	$	3		$	(4	)	$	(2	)	$	(9	)	$	1		$	(2	)
Gains (Losses) Recorded to: ⁽¹⁾
Gains (Losses) Recorded ⁽¹⁾
Regulatory Assets or Liabilities, Derivative Instruments	1			10			3			(3		)	1			(1		)
Wholesale Revenues	—			—			3			3
Settlements	(1		)	(6		)	(1		)	9			(1		)	—
End of Period	$	3		$	—		$	3		$	—		$	1		$	(3	)


⁽¹⁾	Includes gains (losses) attributable to the change in unrealized gains (losses) relating to assets (liabilities) still held at the end of the period of ~~less than~~ $1 million and ~~$(2)~~$(1) million for the three months ended ~~September 30,~~March 31, 2017 and 2016, ~~and 2015, respectively, and $3 million and $1 million for the nine months ended September 30, 2016 and 2015,~~ respectively.

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. ~~We enter~~TEP enters into contracts for the physical delivery of ~~energy~~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.

~~We have~~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, ~~we,~~the Company, or ~~our~~its counterparties, would have to provide certain credit enhancements in the form of cash, a Letter of Credit (LOC), or other acceptable security to collateralize exposure beyond the allowed amounts.

~~We consider~~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 ~~allocate~~allocates the credit risk adjustment to individual contracts. WeTEP also ~~consider~~considers the impact of ~~our own~~its credit risk on instruments that are in a net liability position, after considering collateral posted, and then ~~allocate~~allocates the credit risk adjustment to all 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 ~~$16~~$12 million ~~at September 30, 2016,~~as of March 31, 2017, compared with ~~$20~~$8 million atas of December 31, ~~2015. At September 30, 2016,~~2016. As of March 31, 2017, TEP had no LOCs as credit enhancements with its counterparties. If the credit risk contingent features were triggered on ~~September 30, 2016,~~March 31, 2017, TEP would have been required to post an additional ~~$16~~$12 million of collateral of which ~~$14~~$7 million relates to outstanding net payable balances for settled positions.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

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. ~~We use~~TEP uses the following methods and assumptions for estimating the fair value of ~~our~~ financial instruments:

Borrowings under revolving credit facilities approximate the 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, ~~we use~~TEP uses quoted market prices, when available, or ~~calculate~~calculates the present value of remaining cash flows at the balance sheet date. When calculating present value, ~~we use~~the Company uses current market rates for bonds with similar characteristics such as credit rating and time-to-maturity. ~~We consider~~TEP considers the principal amounts of variable rate debt outstanding to be reasonable estimates of the fair value. WeThe Company also ~~incorporate~~incorporates the impact of ~~our~~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 ~~our~~TEP's long-term debt:


	Fair Value Hierarchy	Face Value				Fair Value				Fair Value Hierarchy	Face Value				Fair Value
(in millions)		September 30, 2016		December 31, 2015		September 30, 2016		December 31, 2015			March 31, 2017		December 31, 2016		March 31, 2017		December 31, 2016
Liabilities
Long-Term Debt, including Current Maturities	Level 2	$	1,466	$	1,466	$	1,548	$	1,529	Level 2	$	1,466	$	1,466	$	1,490	$	1,472

NOTE 10.RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

~~We consider~~TEP considers the applicability and impact of all ~~Accounting Standards Updates~~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 ~~either not~~ applicable or are expected to have minimal impact on ~~our~~TEP's condensed consolidated financial position, results of operations, or disclosures.

REVENUE FROM CONTRACTS WITH CUSTOMERS

In May 2014, the FASB issued an accounting ~~standards~~standard update that will eliminate the transaction and industry-specific revenue recognition guidance under current GAAP and replace it with a ~~principles based~~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 ~~recognize~~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. ~~In July 2015,~~TEP expects to use the ~~FASB voted to defer the effective date of the revenue recognition standard by one year. We are required to adopt the new guidance for annual and interim periods beginning January 1, 2018.~~modified retrospective approach.

Retail and wholesale sales of ~~electricity~~energy based on regulator-approved tariff rates represent TEP’s primary ~~source~~sources of revenue. TEP does not expect that the adoption of this standard will have a material impact on the ~~measurement~~recognition of revenue from energy sales to retail or wholesale customers. ~~TEP is assessing its performance obligations~~Certain industry specific interpretative issues, including contributions in ~~its wholesale contracts~~aid of construction, remain outstanding. The conclusions reached, if different than currently anticipated, could change the Company's expected method of adoption and ~~identifying other contracts with customers.~~

~~CLASSIFICATION AND MEASUREMENT OF FINANCIAL INSTRUMENTS~~

~~In January 2016, the FASB amended the guidance~~have a material impact on the ~~classification and measurement of financial instruments. Most notably, the new accounting standards update requires the following:~~

all equity investments in unconsolidated entities (other than those accounted for using the equity method of accounting) to be measured at fair value through earnings; however, entities will be able to elect to record equity investments without readily determinable fair values at cost, less impairment, and plus or minus subsequent adjustments for observable price changes; and

~~financial assets and financial liabilities to be presented separately in the notes to the~~Company’s consolidated financial statements ~~grouped by measurement category~~ and ~~form of financial asset.~~

~~TEP is required to adopt the new guidance for annual and interim periods beginning January 1, 2018. The accounting standards update is expected to have minimal impact to our financial statements and~~related disclosures.

LEASES

In February 2016, the FASB issued an accounting ~~standards~~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.

~~SHARE-BASED COMPENSATION~~RESTRICTED CASH

In ~~March~~November 2016, the FASB issued an accounting ~~standards~~standard update that ~~simplifies some provisions~~will require entities to show the changes in ~~stock compensation accounting. The update involves several aspects~~the total of ~~the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity~~cash, cash equivalents, and restricted cash or ~~liabilities, and classification~~restricted cash equivalents in the statement of cash flows. ~~The update:~~As a result, entities will no longer present transfers between cash and cash equivalents and restricted cash and restricted cash equivalents in the

2219

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Concluded)

~~requires that all excess tax benefits and tax deficiencies for share-based payment awards be recognized as income tax expense or benefit in the income statement;~~

~~specifies presentation in the~~ statement of cash ~~flows; and~~

~~requires an accounting policy election to estimate the number of awards that are expected to vest or account for forfeitures when they occur.~~

~~TEP~~flows. The standard is ~~required to adopt the new guidance~~effective for annual and interim periods beginning January 1, ~~2017.~~2018, and is to be applied using a retrospective approach. Early adoption is permitted. TEP ~~expects to early adopt this standard in the fourth quarter of 2016, with an effective date of January 1, 2016, and~~ is ~~in the process of determining~~evaluating the impact ~~that the early adoption~~ of this ~~standard will have on~~update to its ~~consolidated~~ financial statements and ~~related~~disclosures.

COMPENSATION—RETIREMENT BENEFITS

In March 2017, the FASB issued an accounting standard update to improve the presentation of net periodic pension cost and net periodic postretirement benefit cost. 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.

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 first ~~nine~~three months of ~~2016~~2017 compared with the same period of ~~2015;~~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 ~~as well as certain non-GAAP~~ financial measures. The non-GAAP financial measures 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~~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 ~~2015~~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: ~~(i)~~ global, national, regional, and local economic conditions; ~~(ii)~~ volatility in the financial markets; ~~(iii)~~ environmental laws and regulations; and ~~(iv)~~ other regulatory factors. Our plans and strategies ~~include:~~include the following:

~~achieving a~~Achieving constructive ~~outcome~~outcomes in our ~~pending rate case proceeding~~regulatory proceedings that ~~provides TEP~~provide us: (i) recovery of ~~its~~our full cost of service and an opportunity to earn an appropriate return on ~~its~~our rate base ~~investments,~~investments; (ii) updated rates tothat provide more accurate price signals and a more equitable allocation of costs to ~~TEP's customers,~~our customers; and ~~enables TEP~~(iii) the ability to continue ~~to provide~~providing safe and reliable service.

~~continuing~~Continuing to focus on our long-term ~~generation~~ 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, ~~optimizing the performance of~~leveraging and improving our existing utility infrastructure, and maintaining financial strength.

developing strategic responses to new environmental regulations and potential new legislation, including new carbon emission standards to reduce greenhouse gas emissions from existing power plants. We are evaluating TEP's existing mix This long-term strategy includes a target of ~~generation resources and defining steps to achieve environmental objectives that protect the financial stability~~meeting 30% of our ~~utility business and the interests of our customers.~~customers’ energy needs with non-carbon emitting resources by 2030.

strengthening the underlying financial condition of TEP by achieving constructive regulatory outcomes, strengthening our capital structure, sustaining our credit ratings, and promoting economic development in our service territory.

~~focusing~~Focusing on our core utility business through operational excellence, promoting economic development in our service territory, investing in ~~utility rate base, emphasizing customer~~infrastructure to ensure reliable service, and maintaining a strong community presence.

~~Table of Contents~~

~~2016~~2017 Operational and Financial Highlights

~~The~~For the first ~~nine~~three months of ~~2016 included~~2017, Management's Discussion and Analysis includes the following notable items:

In February ~~2016, TEP entered into an agreement with~~2017, the ~~Third-Party Owners for the settlement and release of asserted claims and the purchase by TEP of the Third-Party Owners' 50.5% undivided interest~~ACC issued a decision in Springerville Unit 1 for $85 million. In September 2016, the purchase was completed and all asserted claims were dismissed. The Third-Party Owners paid TEP $12.5 million for previously unreimbursed operating costs related to Springerville Unit 1 incurred on behalf of the Third-Party Owners.

In March 2016, Tri-State notified TEP that it was exercising its option to purchase a 17.05% undivided interest in the Springerville Coal Handling Facilities for approximately $24 million. The Tri-State purchase is expected to close by the end of 2016.

~~In March 2016, TEP notified the EPA of its decision to permanently eliminate coal as a fuel source as a better-than-BART alternative at Sundt by no later than December 2017.~~

In April and October 2016, the FERC issued orders relating to certain late-filed TSAs, which resulted in TEP accruing a total of $22 million in time value refunds payable to the counterparties to these TSAs.

~~In August 2016, TEP, ACC Staff, and other parties to TEP's pending~~TEP’s rate case ~~proceeding entered into a partial settlement agreement regarding the revenue requirement. The settlement reflects~~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 ~~7.04% return on original cost rate base. The~~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 ~~requires~~resulting in the ~~approval of the ACC before new rates can become effective.~~counterparty paying TEP $8 million and TEP dismissing a previously filed appeal.

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RESULTS OF OPERATIONS

The following discussion provides the significant items that affected TEP's results of operations in the first ~~nine~~three months of ~~2016~~2017 compared with the same period in ~~2015.~~2016. The significant items affecting net income are presented on an after-tax basis.

The ~~third quarter~~first three months of ~~2016~~2017 compared with the ~~third quarter~~ first three monthsof ~~2015~~2016

TEP reported net income of ~~$72~~$21 million in the ~~third quarter~~first three months of ~~2016~~2017 compared with ~~$69~~a net loss of $1 million in the ~~third quarter~~first three months of ~~2015.~~2016. The increase of $3$22 million, ~~or 4.3%,~~ was primarily due to:

$8 million in ~~higher revenues related~~refunds to ~~the Springerville Unit 1 legal settlement. For further information related to the legal settlement, see Note 6 of Notes to Condensed Consolidated Financial Statements~~counterparties in ~~Part I, Item 1 of this Form 10-Q;~~

~~$1 million increase in the value of company owned life insurance due to favorable market conditions; and~~

~~$1 million in higher net income as a result of a reduction in the valuation allowance for deferred tax assets based on an increase in projected taxable income.~~

~~The increase was partially offset by:~~

~~$5 million in additional accrued refunds~~2016 associated with late-filed ~~TSAs; and~~

~~$2 million in higher depreciation and amortization expenses.~~

~~The first nine months of2016 compared with the first nine months~~of~~2015~~

~~TEP reported net income of $111 million in the first nine months of 2016 compared with $116 million in the first nine months of 2015. The decrease of $5 million, or 4.3%, was primarily due to:~~

~~$13 million in accrued refunds associated with late-filed TSAs; and~~

~~$6 million in higher operations and maintenance expense resulting primarily from increases in maintenance expense due to planned generation outages, outside services, and employee wages and benefits.~~

~~The decrease was partially offset by:~~

~~$8 million in higher revenues related to the Springerville Unit 1 legal settlement. For further information related to the legal settlement, see~~TSAs. See Note ~~6 of Notes~~7 to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q;

$5 million in higher ~~net~~ income in 2017 from a settlement agreement related to the late-filed TSAs;

$3 million in higher retail revenue primarily due to an increase to rates as ~~a result of a reduction~~approved in the ~~valuation allowance for deferred tax assets based on~~2017 Rate Order;

$3 million in higher wholesale revenue primarily due to an increase in ~~projected taxable income;~~volume associated with a new wholesale contract that commenced in 2017, and favorable pricing; and

$23 million in lower operations and maintenance expense resulting primarily from ~~higher LFCR revenues that~~a decrease in maintenance expense due to planned outages in 2016; partially offset ~~lower retail sales.~~by an increase in outside services and employee wages and benefits expense.

~~Retail Sales and Revenues~~

Retail Revenues were ~~$320~~$200 million in the ~~third quarter~~first three months of ~~2016~~2017 compared with ~~$337~~$204 million in the ~~third quarter~~first three months of ~~2015.~~2016. Retail Margin Revenues (non-GAAP) were ~~$207~~$133 million in the ~~third quarter~~first three months of ~~2016~~2017 compared with ~~$209~~$128 million in the ~~third quarter~~first three months of ~~2015.~~2016. The table below provides a summary of retail kWh sales, a reconciliation of Retail Margin Revenues to Retail Revenues, and weather data for the ~~third quarter~~first three months of ~~2016~~2017 and ~~2015:~~2016:


	Three Months Ended September 30,				Increase (Decrease)					Three Months Ended March 31,				Increase (Decrease)
	2016		2015		Amount			Percent		2017		2016		Amount			Percent
Retail Sales by Customer Class (kWh in millions)
Residential	1,344		1,350		(6		)	(0.4	)%	687		697		(10		)	(1.4	)%
Commercial	627		637		(10		)	(1.6	)%	439		440		(1		)	(0.2	)%
Industrial	590		607		(17		)	(2.8	)%	445		453		(8		)	(1.8	)%
Mining	245		279		(34		)	(12.2	)%	244		251		(7		)	(2.8	)%
Public Authorities	6		6		—			—	%	5		9		(4		)	(44.4	)%
Total Retail Sales by Class	2,812		2,879		(67		)	(2.3	)%	1,820		1,850		(30		)	(1.6	)%
Retail Revenues (in millions)
Residential	$	101	$	101	$	—		—	%	$	57	$	53	$	4		7.5	%
Commercial	60		61		(1		)	(1.6	)%	37		35		2			5.7	%
Industrial	30		31		(1		)	(3.2	)%	22		23		(1		)	(4.3	)%
Mining	10		11		(1		)	(9.1	)%	8		8		—			—	%
Public Authorities	—		—		—			—	%	—		1		(1		)	*
Retail Margin Revenues by Class	201		204		(3		)	(1.5	)%	124		120		4			3.3	%
LFCR Revenues	5		3		2			66.7	%	6		5		1			20.0	%
DSM Performance Bonus										2		2		—			—	%
Other Retail Margin Revenues	1		2		(1		)	(50.0	)%	1		1		—			—	%
Retail Margin Revenues (non-GAAP) ⁽¹⁾	207		209		(2		)	(1.0	)%	133		128		5			3.9	%
Fuel and Purchased Power Revenues	98		116		(18		)	(15.5	)%	54		66		(12		)	(18.2	)%
DSM and RES Surcharge Revenues	15		12		3			25.0	%	13		10		3			30.0	%
Total Retail Revenues (GAAP)	$	320	$	337	$	(17	)	(5.0	)%	$	200	$	204	$	(4	)	(2.0	)%
Average Retail Margin Rate by Class (cents/kWh)
Residential	7.51		7.48		0.03			0.4	%	8.30		7.60		0.70			9.2	%
Commercial	9.57		9.58		(0.01		)	(0.1	)%	8.43		7.95		0.48			6.0	%
Industrial	5.08		5.11		(0.03		)	(0.6	)%	4.94		5.08		(0.14		)	(2.8	)%
Mining	4.08		3.94		0.14			3.6	%	3.28		3.19		0.09			2.8	%
Public Authorities ⁽²⁾	5.76		5.78		(0.02		)	(0.3	)%	6.33		5.50		0.83			15.1	%
Average Retail Margin Rate by Class	7.15		7.09		0.06			0.8	%	6.81		6.49		0.32			4.9	%
Total Average Retail Margin Rate ⁽³⁾	7.36		7.26		0.10			1.4	%	7.31		6.92		0.39			5.6	%
Average Fuel and Purchased Power Rate	3.49		4.03		(0.54		)	(13.4	)%	2.97		3.57		(0.60		)	(16.8	)%
Average DSM and RES Surcharge Rate	0.53		0.42		0.11			26.2	%	0.71		0.54		0.17			31.5	%
Total Average Retail Rate	11.38		11.71		(0.33		)	(2.8	)%	10.99		11.03		(0.04		)	(0.4	)%
Weather Data
Cooling Degree Days
Heating Degree Days
Actual	962		1,033		(71		)	(6.9	)%	589		606		(17		)	(2.8	)%
10-year Average	1,018		1,001		*			*		698		731		(33		)	*

* 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: (i) revenues collected from retail customers that are directly offset by expenses recorded in other line items; and (ii) revenues collected from third parties that are unrelated to kWh sales to retail customers. 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

~~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,~~Revenues, DSM Performance Bonus, and certain ~~other retail margin revenues~~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 ~~and Other Retail Margin~~ Revenues, ~~included in Retail Margin Revenues.~~

~~Retail Revenues were lower in the third quarter of 2016 when compared with the same period in 2015, primarily due to a decrease in the PPFAC rate as a result of lower fuel and purchase power costs.~~

Retail Revenues were $781 million in the first nine months of 2016 compared with $803 million in the first nine months of 2015. Retail Margin Revenues (non-GAAP) were $500 million in the first nine months of 2016 compared with $497 million in the first nine months of 2015. The table below provides a summary of retail kWh sales, a reconciliation of Retail Margin Revenues to Retail Revenues, and weather data for the first nine months of 2016 and 2015:

Nine Months Ended September 30, Increase (Decrease)
2016 2015 Amount Percent
Retail Sales by Customer Class (kWh in millions)

Residential 2,990
2,954
36
1.2 %
Commercial 1,633
1,635
(2 ) (0.1 )%
Industrial 1,537
1,590
(53 ) (3.3 )%
Mining 743
832
(89 ) (10.7 )%
Public Authorities 23
23
—
— %
Total Retail Sales by Class 6,926
7,034
(108 ) (1.5 )%
Retail Revenues (in millions)

Residential $ 226
$ 223
$ 3
1.3 %
Commercial 146
147
(1 ) (0.7 )%
Industrial 80
81
(1 ) (1.2 )%
Mining 27
29
(2 ) (6.9 )%
Public Authorities 1
1
—
— %
Retail Margin Revenues by Class 480
481
(1 ) (0.2 )%
LFCR Revenues 14
9
5
55.6 %
DSM Performance Bonus 2
3
(1 ) (33.3 )%
Other Retail Margin Revenues 4
4
—
— %
Retail Margin Revenues (non-GAAP) ⁽¹⁾
500
497
3
0.6 %
Fuel and Purchased Power Revenues 243
270
(27 ) (10.0 )%
DSM and RES Surcharge Revenues 38
36
2
5.6 %
Total Retail Revenues (GAAP) $ 781
$ 803
$ (22 ) (2.7 )%
Average Retail Margin Rate by Class (cents/kWh)

Residential 7.56
7.55
0.01
0.1 %
Commercial 8.94
8.99
(0.05 ) (0.6 )%
Industrial 5.20
5.09
0.11
2.2 %
Mining 3.63
3.49
0.14
4.0 %
Public Authorities ⁽²⁾
5.67
5.66
0.01
0.2 %
Average Retail Margin Rate by Class 6.93
6.84
0.09
1.3 %
Total Average Retail Margin Rate ⁽³⁾
7.22
7.07
0.15
2.1 %
Average Fuel and Purchased Power Rate 3.51
3.84
(0.33 ) (8.6 )%
Average DSM and RES Surcharge Rate 0.55
0.51
0.04
7.8 %
Total Average Retail Rate 11.28
11.42
(0.14 ) (1.2 )%
Weather Data
Cooling Degree Days
Actual 1,431
1,516
(85 ) (5.6 )%
10-year Average 1,491
1,481
*
*
Heating Degree Days
Actual 629
452
177
39.2 %
10-year Average 773
784
*
*

* 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: (i) revenues collected from retail customers that are directly offset by expenses recorded in other line items; and (ii) revenues collected from third parties that are unrelated to kWh sales to retail customers. We believe the change in Retail Margin Revenues between periods provides useful information 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,~~ DSM Performance Bonus, and Other Retail Margin Revenues included in Retail Margin Revenues.

Retail Revenues ~~were lower~~decreased in the first ~~nine~~three months of ~~2016~~2017 when compared with the same period in ~~2015~~2016 primarily due to a decrease in Fuel and Purchased Power Revenues related to the reduction of the PPFAC rate approved by the ACC in May 2016 and the credit approved in February 2017. The decrease was partially offset by higher ~~Retail Margin Revenues. Retail Margin Revenues were higher primarily due~~retail revenues related to an increase in ~~LFCR revenues.~~rates as approved in the 2017 Rate Order.

Wholesale Revenues


	Three Months Ended September 30,					Nine Months Ended September 30,					Three Months Ended March 31,
(in millions)	2016			2015		2016			2015		2017		2016
Long-Term Wholesale	$	6		$	10	$	23		$	29	$	8	$	8
Short-Term Wholesale(1)	26			24		57			80		28		15
Transmission	9			7		23			21		7		7
Transmission Refunds ⁽¹⁾⁽²⁾	(9		)	—		(22		)	—		—		(13		)
Total Wholesale Revenues	$	32		$	41	$	81		$	130	$	43	$	17


⁽¹⁾	Prior period amounts reflect a reclassification between Wholesale Revenues and Purchased Power Expense. See Note 1 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q for additional information.


⁽²⁾	FERC ordered TEP to make refunds associated with various late-filed TSAs for the time period during which rates were charged without FERC authorization. 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 ~~decreased~~increased by $9$26 million ~~or 22.0%,~~ in the ~~third quarter~~first three months of ~~2016~~2017 compared with the same period in ~~2015~~2016 primarily due to ~~additional~~ refunds ~~related~~in 2016 to ~~the late-filed TSAs.~~

~~Wholesale Revenues decreased by $49 million, or~~ ~~37.7%, in the first nine months of 2016 compared~~counterparties associated with ~~the same period in 2015 primarily due to the refunds related to the~~ late-filed TSAs and ~~decreased volumes and market prices of both short-term and long-term wholesale sales resulting from unfavorable market conditions.~~an increase in Short-Term Wholesales volumes.

~~The majority of revenues from short-term wholesale sales~~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 September 30,				Nine Months Ended September 30,				Three Months Ended March 31,
(in millions)	2016		2015		2016		2015		2017		2016
Springerville Units 3 and 4 ⁽¹⁾	$	21	$	24	$	59	$	69	$	19	$	18
Other	21		7		35		20		7		7
Total Other Revenues	$	42	$	31	$	94	$	89	$	26	$	25


⁽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 ~~generating units.~~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 ~~from Springerville Units 3 and 4 decreased~~ in the ~~third quarter and~~ first ~~nine~~three months of ~~2016~~2017 compared with the same periods in ~~2015 primarily due to a decrease in reimbursed costs related to planned generation outages in 2015.~~2016.

Revenues – Other increased in the third quarter and first nine months of 2016 compared with the same periods in 2015 primarily due to the Springerville Unit 1 legal settlement. For further information related to the Springerville Unit 1 legal settlement, see Note 6 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q.

Operating Expenses

~~Generating~~Generation Output and Fuel and Purchased Power Expense

TEP’s fuel and purchased power expense and energy resources are detailed ~~in the following tables:~~below:


	Generation and Purchased Power (kWh)		Fuel and Purchased Power Expense				Generation and Purchased Power (kWh)		Fuel and Purchased Power Expense
	Three Months Ended September 30,						Three Months Ended March 31,
(in millions)	2016	2015	2016		2015		2017	2016	2017			2016
Coal-Fired Generation	2,369	2,362	$	53	$	57	2,009	1,625	$	48		$	42
Gas-Fired Generation	1,060	885	33		34		529	834	17			19
Utility Owned Renewable Generation	17	13	—		—		19	15	—			—
Reimbursed Fuel Expense, Springerville Units 3 and 4 ⁽¹⁾	—	—	1		1		—	—	2			2
Total Generation	3,446	3,260	87		92		2,557	2,474	67			63
Purchased Power, Non-Renewable ⁽²⁾							462	333	14			8
Purchased Power, Renewable							156	153	10			12
Total Purchased Power	604	915	30		40		618	486	24			20
Transmission and Other PPFAC Recoverable Costs	—	—	7		7		—	—	9			5
Increase to Reflect PPFAC Recovery Treatment	—	—	5		10
Increase (Decrease) to Reflect PPFAC Recovery Treatment							—	—	(8		)	7
Total Generation and Purchased Power	4,050	4,175	$	129	$	149	3,175	2,960	$	92		$	95
Less Line Losses and Company Use	224	277					155	151
Total Power Sold	3,826	3,898					3,020	2,809


⁽¹⁾	Springerville Units 3 and 4 Fuel Expense is reimbursed by Tri-State and SRP.


⁽²⁾	Prior period amounts reflect a reclassification between Wholesale Revenues and Purchased Power Expense. See Note 1 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q for additional information.

Fuel and Purchased Power Expense decreased by ~~$20~~$3 million, or ~~13.4%~~3.2%, in the ~~third quarter~~first three months of ~~2016~~2017 compared with the same period in ~~2015~~2016 primarily due to the reduction of the PPFAC rate. The decrease was partially offset by an increase in ~~purchased power~~Coal-Fired Generation volumes and ~~lower~~Purchased Power due to an increase in fuel costs per kWh (see table below).

The ~~decrease was partially offset by the increase in Gas-Fired Generation kWhs.~~

table below summarizes average fuel cost of generated and purchased power kWh:

Generation and Purchased
Power (kWh)

Fuel and Purchased Power
Expense
Nine Months Ended September 30,
(in millions) 2016 2015 2016 2015
Coal-Fired Generation 5,958
6,500
$ 139
$ 167
Gas-Fired Generation 2,711
1,876
74
68
Utility Owned Renewable Generation 51
49
—
—
Reimbursed Fuel Expense, Springerville Units 3 and 4 ⁽¹⁾
—
—
4
4
Total Generation 8,720
8,425
217
239
Total Purchased Power 1,547
2,711
72
108
Transmission and Other PPFAC Recoverable Costs —
—
18
19
Increase to Reflect PPFAC Recovery Treatment —
—
19
21
Total Generation and Purchased Power 10,267
11,136
$ 326
$ 387
Less Line Losses and Company Use 575
611

Total Power Sold 9,692
10,525



	Three Months Ended March 31,
(cents per kWh)	2017	2016
Coal	2.38	2.60
Gas	3.29	2.23
Purchased Power, Non-Renewable	2.98	2.41
Purchased Power, Renewable	6.74	7.79
All Resources ⁽¹⁾	3.31	3.13


⁽¹⁾	~~Springerville Units 3~~Calculated on unrounded data and 4may not correspond exactly to data shown in Generation Output and Fuel and Purchased Power Expense ~~is reimbursed by Tri-State and SRP.~~table above.

Fuel and Purchased Power Expense decreased by $61 million, or 15.8%, in the first nine months of 2016 compared with the same period in 2015 primarily due to the decrease in purchased power volumes, Coal-Fired Generation kWhs, and a decrease in fuel costs per kWh (see table below). The decrease was partially offset by an increase in Gas-Fired Generation kWhs.

~~The table below summarizes average fuel or purchased power cost per kWh:~~

Three Months Ended September 30, Nine Months Ended September 30,
(cents per kWh) 2016 2015 2016 2015
Coal 2.23
2.39
2.34
2.58
Gas 3.07
3.86
2.73
3.61
Purchased Power, Non-Renewable 4.16
3.73
3.11
3.08
Purchased Power, Renewable 6.75
8.67
6.99
10.37
All Sources 3.23
3.58
3.17
3.48

Operations and Maintenance Expense

The table below summarizes the items included in Operations and Maintenance Expense:


	Three Months Ended September 30,				Nine Months Ended September 30,				Three Months Ended March 31,
(in millions)	2016		2015		2016		2015		2017		2016
Reimbursed Expenses, Springerville Units 3 and 4 ⁽¹⁾	$	15	$	17	$	40	$	49	$	12	$	12
Reimbursed Expenses, Customer Funded Renewable Energy and DSM Programs ⁽²⁾	9		7		21		17		6		5
Other(3)	65		64		199		190		64		68
Total Operations and Maintenance Expense	$	89	$	88	$	260	$	256	$	82	$	85


⁽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 three months of 2016.

~~There were no significant changes in~~ Operations and Maintenance Expense decreased by $3 million, or 3.5%, in the ~~third quarter~~first three months of ~~2016~~2017 compared with the same period in ~~2015.~~

~~Operations and Maintenance Expense increased by $4 million, or 1.6%, in the first nine months of~~ 2016 ~~compared with the same period in 2015~~primarily due to ~~an increase~~a decrease in ~~Other Operations and Maintenance Expense~~maintenance expense related to planned ~~generation~~ outages in 2016; partially offset by an increase in outside services and employee wages and ~~benefits. The increase was partially offset by a decrease in Springerville Units 3 and 4 expenses related to planned generation outages in 2015, which were reimbursed by third-party owners.~~benefits expense.

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 ~~2015~~2016 Annual Report on Form 10-K and new regulatory matters occurring in ~~2016.~~2017.

~~2015 Rate Case~~2017 RATE ORDER

In ~~November 2015, TEP filed~~February 2017, the ACC issued a ~~general~~rate order in the rate case ~~with the ACC to: (i) update and improve its~~filed by TEP in November 2015. TEP's rate design and tariffs to provide more accurate price signals and a more equitable allocation of its fixed costs to its customers; (ii) provide TEP with an opportunity to recover its full cost of service, including an appropriate return on its rate base investments; and (iii) enable TEP to continue to provide safe and reliable service. The rate application isfiling 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 ~~key~~ provisions of the ~~rate case include:~~2017 Rate Order include, but are not limited to:

a non-fuel base rate increase of ~~$110~~$81.5 million ~~or 12%, compared with adjusted test year revenues;~~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 ~~7.34%~~7.04% return on original cost rate base of ~~$2.1 billion, which includes~~ approximately ~~$73 million~~$2 billion;

a cost of ~~post-test year adjustments for utility plant that is expected to be in service by December 31, 2016;~~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 ~~cost~~reduction in the depreciable life for San Juan Unit 1; and

approval of ~~equity of 10.35% and an average cost of debt of 4.32%;~~

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;~~retirement.

a request for authority to begin using the Third-Party Owners' portion of Springerville Unit 1 that is available to TEP for dispatch to serve retail customer needs and to recover the related operating costs through the PPFAC; and

rate design changes that would reduce the reliance on volumetric sales to recover fixed costs, and a new net metering tariff that would ensure that customers who install distributed generation pay an equitable price for their electric service.

~~In August 2016, TEP,~~The ACC Staff, and other parties to TEP's pending rate case proceeding entered into a partial settlement agreement regarding the revenue requirement. The settlement reflects a non-fuel base rate increase of $81.5 million and a 7.04% return on original cost rate base. The return on original cost rate base includes a cost of equity component of 9.75% and an average cost of debt component of 4.32%. The non-fuel base rate increase includes the recovery of approximately $15 million of operating costs related to the 50.5% undivided interest in Springerville Unit 1 purchased by TEP in September 2016. Recovery of these costs had previously been requested through the PPFAC. In addition, the settlement agreement reflects the adoption of TEP's proposed depreciation and amortization rates as well as a reduction in the depreciable life for San Juan Unit 1. The settlement agreement requires the approval of the ACC before new rates can become effective.

~~Hearings before an ALJ were held in September 2016, and a ROO is expected in the fourth quarter of 2016. TEP requested new rates to be implemented by January 1, 2017.~~

~~Issues~~deferred matters related to net metering and rate design for ~~distributed generation~~new DG customers ~~have been deferred~~ to ~~a second phase of this rate case proceeding,~~Phase 2, which is expected to be completed by end of 2017. See Phase 2 Proceedings below.

Distributed Generation

In 2016, the ACC held proceedings under the Value and Cost of Distributed Generation (Value of DG) 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 the customer 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 ~~first quarter~~utility’s next rate case.

The initial DG export rate will be established in Phase 2 of ~~2017.~~TEP’s rate case. 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. Hearings are scheduled to begin June 2017 with a final ACC decision expected in late 2017. TEP cannot predict the outcome of ~~this proceeding or whether its rate request will be adopted by the ACC in whole or in part.~~these proceedings.

Generating Resources

~~At September 30, 2016,~~As of March 31, 2017, approximately 52% of TEP's ~~generating~~generation capacity ~~was fueled by coal. Existing and proposed federal environmental regulations, as well as potential changes in state regulation, may increase the cost of operating~~is coal-fired ~~generation facilities.~~generation. TEP is ~~executing strategies and~~ evaluating additional steps to reduce its reliance on ~~coal~~coal-fired generation.

~~In 2015, the on-site coal inventory at Sundt Unit 4 was depleted and the plant began operating on natural gas as~~Integrated Resource Plan

TEP’s long-term strategy to build a ~~primary fuel source. In March 2016, TEP notified the EPA of~~more responsive, sustainable energy portfolio is described in its ~~decision to permanently eliminate coal as a fuel source as a better-than-BART alternative at Sundt Unit 4.~~

~~TEP's ability to further reduce its coal-fired generating capacity will depend on several factors, including, but not limited to:~~

~~the impact of the Clean Power Plan (CPP) on current coal-fired generation facilities; and~~

~~whether TEP chooses to exercise its option to exit San Juan Unit 1 in July 2022 upon the expiration of the current coal supply agreement.~~

~~See~~ ~~Liquidity and Capital Resources, Environmental Matters~~ ~~for additional information regarding the impact of environmental matters on generation plant operations.~~

~~Springerville Unit 1~~

TEP leased Springerville Unit 1 and an undivided one-half interest in certain facilities at Springerville used in common by Springerville Units 1 and 2 under lease agreements accounted for as capital leases. In January 2015, certain leases related to Springerville Unit 1 expired. At that time, TEP purchased a 24.8% undivided ownership interest in Springerville Unit 1 for an aggregate purchase price of $46 million. Following this purchase, TEP owned 49.5% of Springerville Unit 1 and continued to operate the remaining 50.5% on behalf of the Third-Party Owners.

In September 2016, TEP purchased the remaining 50.5% undivided interest in Springerville Unit 1 for $85 million and received $12.5 million for previously unreimbursed operating costs from the Third-Party Owners as part of a settlement agreement.

~~See Note 6 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q for a description of legal proceedings relating to the Third-Party Owners.~~

~~Potential Plant Retirements~~

~~In March 2016, as required by the ACC, TEP filed its 2016 Preliminary~~ Integrated Resource Plan (IRP)~~. A Supplement to the Preliminary IRP was~~ filed ~~on September 30, 2016~~in April 2017 with the ~~final~~ACC. TEP's 2017 IRP discusses continuing efforts to ~~be filed by April 2017. TEP's Preliminary IRP~~diversify its generation portfolio including expanding renewable energy and ~~Supplement disclose TEP's plan to reduce its overall coal capacity by 170 MW in 2017 and outlines options for further reductions through 2031.~~natural gas-fired resources while reducing reliance on coal-fired generating resources. TEP's existing coal generation fleet faces a number of uncertainties ~~related~~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 ~~generation plant participation and final outcomes of state plans for implementing the CPP.~~continue their participation. Given this uncertainty, TEP may consider options that include changes in generation ~~plant~~facility ownership shares, unit shutdowns, or the sale of generation assets to third-parties. TEP ~~plans to~~will seek regulatory recovery for amounts that would not otherwise be recovered if and when any assets are retired.

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 ~~plant operations.~~facility operations.

~~Springerville Coal Handling Facilities~~Navajo Generating Station

Navajo is located on a site that is leased from the Navajo Nation with an initial lease term through 2019. In February 2017, SRP, the operator of Navajo, and the other participants in Navajo, including TEP, announced that they do not currently intend to operate Navajo past the current term of the lease. TEP supports continued operation of the plant through December 2019 if a lease extension can be reached with the Navajo Nation. Without a lease extension, the owners would be forced to cease operations at Navajo this year to allow enough time for decommissioning to be completed before the current lease expires. As of March 31, 2017, TEP's NBV of Navajo was $39 million. Upon the retirement of Navajo, TEP will seek rate recovery of any unrecovered costs.

Long-Term Wholesale Sales

Navopache Electric Cooperative

In April 2015, upon the expiration of the lease term, TEP purchased an undivided ownership interest in the Springerville Coal Handling Facilities. With the completion of this purchase, Tri-State, the lessee of Springerville Unit 3, was obligated to either: (i) buyJanuary 2017, a 17.05% undivided interest in the facilities for approximately $24 million; or (ii) continue to make payments to TEP for the use of the facilities. In March 2016, Tri-State notified TEP that it was exercising its option to purchase the undivided interest in the facilities. The Tri-State purchase is expected to close bynew long-term contract with Navopache Electric Cooperative (NEC) became effective, which expires at the end of ~~2016.~~2041. In 2017, TEP ~~currently collects rent~~expects to serve 80% of ~~$4 million per year related to Tri-State's portion of the Springerville Coal Handling Facilities. At September 30, 2016, the 17.05% undivided interest~~NEC’s load requirements and 100% beginning in ~~the Springerville Coal Handling Facilities that Tri-State plans to buy is classified as Assets Held for Sale on the Condensed Consolidated Balance Sheets.~~

~~Sales to Mining Customers~~

TEP's largest mining customer has taken steps to reduce operational expenses by curtailing production in 2016 due to a decline in commodity prices. As a result, retail sales to mining customers have declined by 10.7% in the first nine months of 2016 when compared with the same period in 2015. While TEP cannot predict how long commodity prices will remain low or the total impact the prices will have on mining production in the future, any future curtailment of mining production could negatively impact retail sales for mining customers.2018. In the ~~first nine~~three months ~~of 2016, mining customers~~ended March 31, 2017, NEC accounted for ~~10.7%~~34% of ~~TEP's retail sales and 3.5% of Retail~~total Long-Term Wholesale Revenues.

Interest Rates

See Part II, Item 7A in our ~~2015~~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)	September 30, 2016		March 31, 2017
Cash and Cash Equivalents	$	57	$	35
Amount Available under Revolving Credit Facility ⁽¹⁾	250		250
Total Liquidity	$	307	$	285


⁽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 ~~2015~~2016 Annual Report on Form 10-K and the material changes summarized below in the respective sections.

Summary of Cash Flows

The table below presents net cash provided by (used for) operating, investing, and financing activities:


	Nine Months Ended September 30,						Increase (Decrease)		Three Months Ended March 31,						Increase (Decrease)
(in millions)	2016			2015			Percent		2017			2016			Percent
Operating Activities	$	341		$	266		28.2	%	$	98		$	95		3.2	%
Investing Activities	(302		)	(419		)	(27.9	)%	(89		)	(81		)	9.9	%
Financing Activities	(38		)	146			(126.0	)%	(10		)	(9		)	(11.1	)%
Net Increase (Decrease) in Cash	1			(7		)	114.3	%	(1		)	5			(120.0	)%
Cash and Cash Equivalents, Beginning of Period	56			74			(24.3	)%	36			55			(34.5	)%
Cash and Cash Equivalents, End of Period	$	57		$	67		(14.9	)%	$	35		$	60		(41.7	)%

Operating Activities

In the first ~~nine~~three months of ~~2016,~~2017, net cash flows from operating activities increased by ~~$75~~$3 million compared with the same period in ~~2015~~2016 primarily due to a:

~~$43 million decrease in cash paid for fuel and purchased power costs;~~

~~$16 million decrease in cash paid for pension and retiree funding;~~

~~$12.5~~an $8 million increase in cash proceeds received in 2017 for the settlement related to the ~~settlement of operating costs related to Springerville Unit 1 incurred on behalf of the Third-Party Owners;~~

~~$10 million decrease in cash paid for operations and maintenance costs of remote generating stations; and~~

~~$4 million decrease in cash paid for interest on debt and capital leases, net of amounts capitalized.~~

~~The increase was~~FERC Refund Orders transmission refunds settlement; partially offset by ~~an increase of $11~~a $4 million unfavorable change in ~~cash paid for incentive compensation~~working capital primarily due to fluctuations in the ~~first nine months~~timing of 2016 compared with the same period in 2015. As a result of the Fortis acquisition in 2014, payments under the annual incentive compensation plan were accelerated to the third quarter of 2014 from the first quarter of 2015.billing collections and payments.

Investing Activities

In the first ~~nine~~three months of ~~2016,~~2017, net cash flows used for investing activities ~~decreased~~increased by ~~$117~~$8 million compared with the same period in ~~2015~~2016 primarily due to a:

~~$120 million purchase in April 2015 of~~ an ~~additional 86.7% undivided ownership interest in the Springerville Coal Handling Facilities increasing its total ownership interest to 100%; and~~

~~$72 million decrease in cash paid in 2016 for capital expenditures primarily due to construction cost in 2015 of a new 500kV transmission line.~~

~~The decrease in net cash flows used for investing activities was partially offset by a:~~

$85 million purchase in September 2016 of a 50.5% undivided ownership interest in Springerville Unit 1 compared to a $46 million purchase in January 2015 of a 24.8% undivided ownership interest in the same generation facility;

~~$24 million in cash proceeds in May 2015 for the sale of a 17.05% undivided ownership interest in Springerville Coal Handling Facilities to SRP;~~

~~$9 million~~ increase in cash paid ~~in 2016~~ for ~~the purchase of renewable energy credits; and~~

~~$4 million decrease in cash proceeds in 2016 for contributions in aid of construction.~~capital expenditures.

Financing Activities

In the first ~~nine~~three months of ~~2016,~~2017, there were no significant changes to net cash flows from financing activities ~~decreased by $184 million~~ compared with the same period in ~~2015 primarily due to a:~~2016.

~~$299 million decrease in cash proceeds in 2016 for the issuance of long-term debt in February 2015; and~~

~~$180 million decrease in cash proceeds in 2016 from a UNS Energy equity contribution in June 2015.~~

~~The decrease in net cash flows from financing activities was partially offset by a:~~

~~$209 million decrease in cash paid in 2016 for the purchase of $130 million in tax-exempt long-term debt in January 2015, and the retirement of $79 million in long-term debt in August 2015; and~~

~~$85 million decrease in cash paid in 2016, net of proceeds borrowed, under TEP's revolving credit facilities.~~

External Sources of Liquidity

Short-Term Investments

~~TEP’s~~Our short-term investment policy governs the investment of excess cash balances. We periodically review and update this policy in response to market conditions. ~~At September 30, 2016,~~As of March 31, 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. ~~No amounts were drawn~~As of March 31, 2017, there was $250 million available under ~~TEP's~~the revolving credit ~~facility at September 30, 2016.~~commitments and LOC facilities. As of May 1, 2017, we had $235 million available under the revolving credit commitments and LOC facilities.

For details onof TEP's credit facility see Note 56 of Notes to ~~Condensed~~ Consolidated Financial Statements in Part I,II, Item ~~1 of this~~8 in our 2016 Annual Report on Form ~~10-Q~~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 January 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.

We have no plans to raise additional capital in ~~2016 or~~ 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

~~Our credit~~Credit ratings affect our access to capital markets and supplemental bank financing. ~~At September 30, 2016, TEP’s~~As of March 31, 2017, Moody’s Investors Service credit ratings for TEP’s senior unsecured debt ~~were A3 from Moody’s and BBB+ from~~remained unchanged at A3. In April 2017, S&P Global ~~Ratings.~~Ratings upgraded TEP’s credit rating on senior unsecured debt to A- from BBB+.

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. ~~At September 30, 2016,~~As of March 31, 2017, TEP was in compliance with these covenants.

TEP conducts its wholesale marketing and risk management activities under certain master agreements whereby TEP may be required to post credit enhancements in the form of cash or a LOC due to exposures exceeding unsecured credit limits provided to TEP, changes in contract values, a change in TEP’s credit ratings, or if there has been a material change in TEP’s creditworthiness. At September 30, 2016, TEP had no LOCs as credit enhancements with its counterparties.

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 March 31, 2017, TEP had posted no LOCs as credit enhancements with its counterparties.

Contribution from Parent

TEP received no equity contributions in the ~~first nine~~three months ofended March 31, 2017 or 2016. ~~In June 2015, UNS Energy made an equity contribution of $180 million to TEP. The contribution was used to repay revolving credit loans, redeem bonds, and provide additional liquidity to TEP.~~

Dividends Paid to Parent

The ACC's approval of the acquisition of UNS Energy by Fortis in August 2014 contained a condition restricting TEP's dividend payments to UNS Energy to no more than 60% of TEP's annual net income for the earlier of five years or until such time that TEP's equity capitalization reached 50% as accounted for in accordance with GAAP. In June 2016, TEP reached the equity capitalization threshold.

Capital Expenditures

TEP's routine capital expenditures include funds used for customer growth, system reinforcement, replacements and betterments, and costs to comply with environmental rules and regulations. In the first ~~nine~~three months of ~~2016,~~2017, there have been no changes in TEP's forecasted capital expenditures from those reported in our ~~2015~~2016 Annual Report on Form 10-K, other than normal recurring subsequent review ~~adjustments and the $85 million purchase of the Third-Party Owners' 50.5% undivided ownership interest in Springerville Unit 1 that occurred in September 2016.~~adjustments.

Contractual Obligations

In the first ~~nine~~three months of ~~2016,~~2017, there have been no changes in TEP's contractual obligations or other ~~commercial~~financial commitments from those reported in our ~~2015~~2016 Annual Report on Form 10-K, other than long-term commitments entered into by TEP through ~~September 30, 2016,~~March 31, 2017, as described in Note 6 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q.

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 ~~nine~~three months of ~~2016~~2017 and does not expect to make any payments until 2020.

~~Off-Balance Sheet Arrangements~~

Other than the unrecorded contractual obligations reported on the contractual obligations table presented in our 2015 Annual Report on Form 10-K, we do not have any arrangements or relationships with entities that are not consolidated into the financial statements.

Environmental Matters

The EPA regulates the amount of sulfur dioxide (SO₂), nitrogen oxide (NO_x), carbon dioxide (CO₂), particulate matter, mercury and other by-products produced by ~~power plants.~~generation facilities. TEP may incur ~~added~~additional costs to comply with future changes in federal and state environmental laws, regulations, and permit requirements at its ~~power plants.~~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 ~~from its ratepayers.~~

~~Hazardous Air Pollutant Requirements~~

In February 2012, the EPA issued final rules for the control of mercury emissions and other hazardous air pollutants from power plants. Based on the EPA's final Mercury and Air Toxics Standards (MATS) rules, additional emission control equipment would have been required by April 2015. TEP, as operator of Springerville and Sundt, and the operators of Navajo and Four Corners received extensions until April 2016 to comply with the MATS rules.

In June 2015, the D.C. Circuit Court of Appeals remanded the MATS rules to the EPA for further consideration. Despite the June 2015 ruling, TEP proceeded with its planned MATS compliance activity at each generating station.

In March 2016, the installation of mercury control systems was completed at Navajo. TEP’s share of the installation costs were approximately $1 million. In addition, TEP completed the installation of mercury control systems on Units 1 and 2 at Springerville in March 2016. TEP’s share of the installation costs were approximately $3 million. At this time, all generating stations TEP operates or is a participant in are in compliance with the MATS rules.through Retail Rates.

Regional Haze Rules

The EPA's Regional Haze Rules require emission controls known as ~~BART~~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 ~~power plants.~~generation facilities.

In the western ~~U.S.,~~United States, Regional Haze BART determinations have focused on controls for NO_x, often resulting in a requirement to install Selective Catalytic ~~Reduction (SCR). Complying~~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 ~~power plants.~~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 ~~2018.~~2021. In ~~May~~December 2016, the EPA ~~published~~signed a ~~proposed~~final rule, entitled "Protection of Visibility: Amendments to Requirements for State Plans." Among other things, the rule ~~proposes to change~~changes the date for submittal of the next regional haze implementation plan from 2018 to ~~2021, extending the time for potential impact~~2021. Based on recent Regional Haze requirement time-frames, TEP anticipates that impacts, if any, to Springerville will likely occur three to ~~2021.~~five years after the 2021 plan submittal date. TEP cannot predict the ultimate outcome of these matters.

TEP's estimated NO_x emissions control costs to comply with the rules ~~includes~~include the following:



(in millions)	Navajo		Four Corners
Capital Expenditures	$	47	$	44
Annual Operations and Maintenance Expenses	2		2
Compliance Year	2030		2018

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~~Selective Catalytic Reduction (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 plant. The plant has until December 2019 to notify the EPA of how it will comply with the FIP.

In February 2017, SRP, the operator of Navajo, and the other participants in Navajo, including TEP, announced that they do not currently intend to operate Navajo past the current term of the lease. Without a lease extension, the owners would be forced to cease operations at Navajo this year to allow enough time for decommissioning to be completed before the current lease expires. See Part I, Item 2. Factors Affecting Results of Operations, Generating Resources for more information.

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 SCR on Units 4 and 5 by July 2018. TEP owns 7% of Four Corners Units 4 and 5.

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 ~~SNCR~~Selective Non-Catalytic Reduction (SNCR) on Units 1 and 4. TEP owns 50% of

Units 1 and 2 at San Juan. PNM, the operator of San Juan, completed the installation of SNCR in February 2016. TEP's share of installation costs were $12 million. ~~PNM~~Public Service Company of New Mexico (PNM) obtained New Mexico Public Regulation Commission approval to shut down Units 2 and 3 at San Juan.

~~At September 30, 2016, the NBV of TEP's share in San Juan Unit 2 was $99 million. Consistent with the 2013 Rate Order,~~ TEP ~~has requested authorization from the ACC to apply~~applied excess depreciation reserves against the unrecovered NBV as approved in ~~its 2015~~the 2017 Rate ~~Case.~~Order. See Note 2 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q for ~~developments in~~a list of key provisions of the ~~2015~~2017 Rate ~~Case.~~Order.

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 as approved in the 2017 Rate Order. See Note 2 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q for ~~additional information.~~a list of key provisions of the 2017 Rate Order.

Greenhouse Gas Regulation

In August 2015, the EPA issued the CPP limiting CO₂ emissions from existing and new fossil fueled ~~power plants.~~generation facilities. The ~~CPP~~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 ~~power plants~~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 Regional Haze compliance will be equivalent to those required under the CPP rule. ~~TEP cannot predict the ultimate outcome of these matters.~~

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 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 court is also inviting briefs from the parties on whether the rules should be remanded to the agency for further review. Those briefs are due May 15, 2017.

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. On April 4, 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.

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 the ~~ruling.~~

In September 2016, the D.C. Circuit Court of Appeals heard oral arguments on the CPP, before an en banc court. A decision is not expected until late 2016 or early 2017. TEP will continue to work with the other Arizonarecent EO and New Mexico utilities, as well as the appropriate regulatory agencies, to develop the state compliance plans. TEP is unable to determine how the final CPP rule will impact its facilities until state plans are developed and approved by the EPA.court decisions. 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 ~~the cost~~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 ~~the~~ 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.

On December 10, 2016, Congress approved the Water Infrastructure Improvements for the Nation Act (WIIN 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. ~~Our management~~Management believes that there have been no significant changes during the ~~nine~~three months ended ~~September 30, 2016,~~March 31, 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 ~~2015~~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.

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 ~~2015~~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 Securities and Exchange Commission’s rules and forms. These disclosure controls and procedures are also designed to ensure that information required to be disclosed by 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 ~~September 30, 2016.~~March 31, 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 internal control over financial reporting during the ~~nine~~three months ended ~~September 30, 2016,~~March 31, 2017, that has materially affected, or is reasonably likely to materially affect, TEP’s internal control over financial reporting.

PART II

ITEM 1. LEGAL PROCEEDINGS

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

As previously reported, TEP and the Third-Party Owners were parties to litigation and arbitration proceedings relating to Springerville Unit 1. In February 2016, TEP entered into an agreement with the Third-Party Owners for the settlement and release of asserted claims and the purchase and sale of beneficial interests in Springerville Unit 1 (Agreement).

In September 2016, TEP received FERC authorization to complete the transactions contemplated in the Agreement. In accordance with the Agreement, TEP purchased the undivided interest in Springerville Unit 1 for $85 million, and received $12.5 million from the Third-Party Owners in full satisfaction of all previously unreimbursed operating costs. Following the purchase, all outstanding disputes, pending litigation, and arbitration proceedings between TEP and the Third-Party Owners were dismissed with prejudice.

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 ~~2015~~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 ~~2015~~2016 Form 10-K.

ITEM 5. OTHER INFORMATION

RATIO OF EARNINGS TO FIXED CHARGES

Nine Months Ended Twelve Months Ended
September 30, 2016 September 30, 2016
Ratio of Earnings to Fixed Charges 4.16
3.71



	Three Months Ended	Twelve Months Ended
	March 31, 2017	March 31, 2017
Ratio of Earnings to Fixed Charges	2.71	4.16

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.

4134

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:	~~November 4, 2016~~May 2, 2017	/s/ ~~Kevin~~Frank P. ~~Larson~~Marino
		~~Kevin~~Frank P. ~~Larson~~Marino
		~~Senior~~ Vice President and Chief Financial Officer
		(~~On behalf of the registrant and as~~ Principal Financial Officer)

4235

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 ~~Kevin~~Frank P. ~~Larson~~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.

4336



Definitions	iii
Forward-Looking Information	v
PART I

Item 1. Financial Statements
Condensed Consolidated Statements of Income (Loss)	1
Condensed Consolidated Statements of Comprehensive Income (Loss)	2
Condensed Consolidated Statements of Cash Flows	3
Condensed Consolidated Balance Sheets	4
Condensed Consolidated Statements of Changes in Stockholder's Equity	6
Notes to Condensed Consolidated Financial Statements	7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	2421
Critical Accounting Policies and Estimates	4032
Accounting Pronouncements	4033
Item 3. Quantitative and Qualitative Disclosures about Market Risk	4033
Item 4. Controls and Procedures	4033

PART II

Item 1. Legal Proceedings	4134
Item 1A. Risk Factors	4134
Item 5. Other Information	4134
Item 6. Exhibits	4134
Signatures	4235
Exhibit Index	4336



	Nine Months Ended	Twelve Months Ended
	September 30, 2016	September 30, 2016
Ratio of Earnings to Fixed Charges	4.16	3.71