Fair Value Measurements

12 Months Ended

Dec. 31, 2012

Fair Value Measurements

NOTE 11. FAIR VALUE MEASUREMENTS

We categorize our assets and liabilities at fair value into the three-level hierarchy based on inputs used to determine the fair value measurement. 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. Level 3 inputs are unobservable and supported by little or no market activity.

The following tables present, by level within the fair value hierarchy, UNS Energy’s and 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 significant to the fair value measurement. There were no transfers between Levels 1, 2, or 3 for either reporting period.

	UNS Energy
	Level 1		Level 2			Level 3			Total
	December 31, 2012
	- Millions of Dollars -
Assets
Cash Equivalents(1)	$	20	$	—		$	—		$	20
Rabbi Trust Investments to Support the Deferred Compensation and SERP Plans(2)		—		19			—			19
Energy Contracts(3)		—		2			5			7
Total Assets		20		21			5			46
Liabilities
Energy Contracts(3)		—		(7	)		(10	)		(17	)
Interest Rate Swaps(4)		—		(10	)		—			(10	)
Total Liabilities		—		(17	)		(10	)		(27	)
Net Total Assets and (Liabilities)	$	20	$	4		$	(5	)	$	19

	UNS Energy
	Level 1		Level 2			Level 3			Total
	December 31, 2011
	- Millions of Dollars -
Assets
Cash Equivalents(1)	$	23	$	—		$	—		$	23
Rabbi Trust Investments to Support the Deferred Compensation and SERP Plans(2)		—		16			—			16
Energy Contracts(3)		—		—			14			14
Total Assets		23		16			14			53
Liabilities
Energy Contracts(3)		—		(21	)		(24	)		(45	)
Interest Rate Swaps(4)		—		(12	)		—			(12	)
Total Liabilities		—		(33	)		(24	)		(57	)
Net Total Assets and (Liabilities)	$	23	$	(17	)	$	(10	)	$	(4	)

	TEP
	Level 1		Level 2			Level 3			Total
	December 31, 2012
	- Millions of Dollars -
Assets
Cash Equivalents(1)	$	7	$	—		$	—		$	7
Rabbi Trust Investments to Support the Deferred Compensation and SERP Plans(2)		—		19			—			19
Energy Contracts(3)		—		1			2			3
Total Assets		7		20			2			29
Liabilities
Energy Contracts(3)		—		(3	)		(2	)		(5	)
Interest Rate Swaps(4)		—		(10	)		—			(10	)
Total Liabilities		—		(13	)		(2	)		(15	)
Net Total Assets and (Liabilities)	$	7	$	7		$	—		$	14

	TEP
	Level 1		Level 2			Level 3			Total
	December 31, 2011
	- Millions of Dollars -
Assets
Cash Equivalents(1)	$	8	$	—		$	—		$	8
Rabbi Trust Investments to Support the Deferred Compensation and SERP Plans(2)		—		16			—			16
Energy Contracts(3)		—		—			3			3
Total Assets		8		16			3			27
Liabilities
Energy Contracts(3)		—		(9	)		(3	)		(12	)
Interest Rate Swaps(4)		—		(11	)		—			(11	)
Total Liabilities		—		(20	)		(3	)		(23	)
Net Total Assets and (Liabilities)	$	8	$	(4	)	$	—		$	4

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

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

⁽³⁾  Energy Contracts include gas swap agreements (Level 2), gas and power options (Level 3), forward power purchase and sales contracts (Level 3), and forward power purchase contracts indexed to gas (Level 3), entered into to reduce exposure to energy price risk. These contracts are included in Other Assets and Derivative Instruments on the balance sheets. The valuation techniques are described below. See Note 16.

⁽⁴⁾  Interest Rate Swaps are valued based on the 3-month or 6-month LIBOR index or the Securities Industry and Financial Markets Association municipal swap index. These interest rate swaps are included in Derivative Instruments on the balance sheets.

Energy Contracts

We primarily apply the market approach for recurring fair value measurements. When we have observable inputs for substantially the full term of the asset or liability, such as gas swap derivatives valued using New York Mercantile Exchange pricing adjusted for basis differences, we categorize the instrument in Level 2. We categorize derivatives in Level 3 when we use an aggregate pricing service or published prices that represent a consensus reporting of multiple brokers.

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

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

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

Our assessments of the significance of a particular input to the fair value measurements requires judgment and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels. We review the assumptions underlying our contracts monthly.

The following table provides quantitative information regarding significant unobservable inputs in UNS Energy’s Level 3 fair value measurements:

	Fair Value at December 31, 2012					Range of
	Assets		Liabilities			Unobservable Input
	-Millions of Dollars-
Forward Contracts(1)		$4		$	(10)
Valuation Technique: Market approach
Unobservable Input:
Market price per MWh							$19.50 - $ 56.24
Option Contracts(2)		1		—
Valuation Technique: Option model
Unobservable Inputs:
Market Price per MWh							$29.50 - $ 46.00
Power Volatility							30.38% - 59.95%
Market Price per MMbtu							$3.22 - $ 3.84
Gas Volatility							29.32% - 36.14%
Level 3 Energy Contracts		$5		$	(10)

⁽¹⁾  TEP comprises $1 million of the forward contract assets and $2 million of the forward contract liabilities.

⁽²⁾  The option contracts relate to TEP.

Our exposure to risk resulting from changes in the unobservable inputs identified above is mitigated as we report the change in fair value of energy contract derivatives as a regulatory asset or a regulatory liability. These are recoverable through the PPFAC or PGA mechanisms, or as a component of other comprehensive income, rather than in the income statements.

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

	Year Ended December 31, 2012
	UNS Energy			TEP
	Energy Contracts
	-Millions of Dollars-
Balance as of December 31, 2011	$	(10	)	$	—
Realized/Unrealized Gains/(Losses)Recorded to:
Net Regulatory Assets/Liabilities – Derivative Instruments		(5	)		1
Settlements		10			(1	)
Balance as of December 31, 2012	$	(5	)	$	—
Total Gains/(Losses) Attributable to the Change in Unrealized Gains/(Losses) Relating to Assets/Liabilities Still Held at the End of the Period	$	(1	)	$	—

	Year Ended December 31, 2011
	UNS Energy			TEP
	Energy Contracts
	-Millions of Dollars-
Balance as of December 31, 2010	$	(10	)	$	1
Realized/Unrealized Gains/(Losses) Recorded to:
Net Regulatory Assets/Liabilities – Derivative Instruments		(9	)		2
Other Comprehensive Income		(1	)		(1	)
Settlements		10			(2	)
Balance as of December 31, 2011	$	(10	)	$	—
Total Gains/(Losses) Attributable to the Change in Unrealized Gains/(Losses) Relating to Assets/Liabilities Still Held at the End of the Period	$	(9	)	$	—

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 the following methods and assumptions for estimating the fair value of our financial instruments:

• The carrying amounts of our current assets and liabilities, including current maturities of long-term debt, and amounts outstanding under our credit agreements, which approximate the fair values due to the short-term nature of these financial instruments. These items have been excluded from the table below.

• For Investment in Lease Debt, we calculate the present value of remaining cash flows using current market rates for instruments with similar characteristics such as credit rating and time-to-maturity. We also incorporate the impact of counterparty credit risk using market credit default swap data.

• For Investment in Lease Equity, we estimate the price at which an investor would realize a target internal rate of return. Our estimates include: the mix of debt and equity an investor would use to finance the purchase; the cost of debt; the required return on equity; and income tax rates. The estimate assumes a residual value based on an appraisal of Springerville Unit 1 in 2011.

• For Long-Term Debt, we use quoted market prices, where available, or calculate the present value of remaining cash flows at the balance sheet date. When calculating present value, we use current market rates for bonds with similar characteristics such as credit rating and time-to-maturity. We consider the principal amounts of variable rate debt outstanding to be reasonable estimates of the fair value. We also incorporate the impact of our own credit risk using a credit default swap rate.

The use of different estimation methods and/or market assumptions may yield different estimated fair value amounts. The carrying value recorded on the balance sheet and the estimated fair values of our financial instruments were as follows:

			December 31,
			2012				2011
	Fair Value Hierarchy		Carrying Value		Fair Value		Carrying Value		Fair Value
			-Millions of Dollars-
Assets:
TEP Investment in Lease Debt		Level 2	$	9	$	9	$	29	$	29
TEP Investment in Lease Equity		Level 3		36		23		37		21
Liabilities:
Long-Term Debt
UNS Energy		Level 2		1,498		1,583		1,517		1,543
TEP		Level 2		1,223		1,271		1,080		1,061

TEP held the Investment in Lease Debt to maturity in January 2013. This investment was stated at amortized cost, which means the purchase cost had been adjusted for the amortization of the premium and discount to maturity.

The fair value of TEP’s Long-Term Debt increased from prior year because of a change in valuation methodology concerning the make-whole premium applied to the bonds if they are called early.