Filed by Bowne Pure Compliance

UniSource Energy Corporation

Large Accelerated Filer þ

Accelerated Filer o

Non-accelerated filer o

Smaller Reporting Company o

Tucson Electric Power Company

Large Accelerated Filer o

Accelerated Filer o

Non-accelerated filer þ

Smaller Reporting Company o

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to .


Commission	Registrant; State of Incorporation;	IRS Employer
File Number	Address; and Telephone Number	Identification Number

1-13739	UNISOURCE ENERGY CORPORATION	86-0786732
	(An Arizona Corporation)
	One South Church Avenue, Suite 100
	Tucson, AZ 85701
	(520) 571-4000

1-5924	TUCSON ELECTRIC POWER COMPANY	86-0062700
	(An Arizona Corporation)
	One South Church Avenue, Suite 100
	Tucson, AZ 85701
	(520) 571-4000

Indicate by check mark whether each registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer,” “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).


UniSource Energy Corporation	Yes o	No þ
Tucson Electric Power Company	Yes o	No þ

At November 4, 2008, 35,494,089 shares of UniSource Energy Corporation Common Stock, no par value (the only class of Common Stock), were outstanding.

At November 4, 2008, 32,139,434 shares of Tucson Electric Power Company’s common stock, no par value, were outstanding, all of which were held by UniSource Energy Corporation.

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

DEFINITIONS

The abbreviations and acronyms used in the 2008 third quarter report on Form 10-Q are defined below:


ACC		Arizona Corporation Commission.
AECC		Arizonans for Electric Choice and Competition.
AMT		Alternative Minimum Tax.
APS		Arizona Public Service.
BMGS		Black Mountain Generating Station owned by UED.
Btu		British thermal unit(s).
Capacity		The ability to produce power; the most power a unit can produce or the maximum that can be taken under a contract, measured in MWs.
Citizens		Citizens Communications Company.
Common Stock		UniSource Energy’s common stock, without par value.
Company or UniSource Energy		UniSource Energy Corporation.
Cooling Degree Days		An index used to measure the impact of weather on energy usage calculated by subtracting 75 from the average of the high and daily low temperatures.
DSM		Demand side management.
Emission Allowance(s)		An allowance issued by the Environmental Protection Agency which permits emission of one ton of sulfur dioxide or one ton of nitrogen oxide. These allowances can be bought and sold.
Energy		The amount of power produced over a given period of time measured in MWh.
ESP		Energy Service Provider.
FAS 71		Statement of Financial Accounting Standards No. 71: Accounting for The Effects of Certain Types of Regulation.
FAS 133		Statement of Financial Accounting Standards No. 133: Accounting for Derivative Instruments and Hedging Activities, as amended.
FAS 143		Statement of Financial Accounting Standards No. 143: Accounting for Asset Retirement Obligations.
FERC		Federal Energy Regulatory Commission.
Fixed CTC		Competition Transition Charge of approximately $0.009 per kWh that is included in TEP’s retail rate for the purpose of recovering TEP’s $450 million TRA by December 31, 2008.
Four Corners		Four Corners Generating Station.
Heating Degree Days		An index used to measure the impact of weather on energy usage calculated by subtracting the average of the high and low daily temperatures from 65.
ICRA		Implementation Cost Regulatory Asset.
IDBs		Industrial Development Revenue Bonds.
IRS		Internal Revenue Service.
kWh		Kilowatt-hour(s).
LIBOR		London Interbank Offered Rate.
Luna		Luna Energy Facility.
Mark-to-Market Adjustments		Unrealized gains and losses that are recorded monthly yo reflect the market prices at the end of each month on forward energy sales and purchase contracts that are considered to be derivatives.
Millennium		Millennium Energy Holdings, Inc., a wholly-owned subsidiary of UniSource Energy.
MMBtu		Million British Thermal Units.
MW		Megawatt(s).
MWh		Megawatt-hour(s).
Navajo		Navajo Generating Station.
PGA		Purchased Gas Adjuster, a retail rate mechanism designed to recover the cost of gas purchased for retail gas customers.
Pima Authority		The Industrial Development Authority of the County of Pima.
PPFAC		Purchased Power and Fuel Adjustment Clause.


PWMT		Pinnacle West Marketing and Trading.
REST		Renewable Energy Standard and Tariff.
RUCO		Residential Utility Consumer Office.
Salt River Project		A public power utility serving more than 900,000 customers in Phoenix, Arizona.
San Juan		San Juan Generating Station.
1999 Settlement Agreement		TEP’s 1999 Settlement Agreement approved by the ACC in November 1999 that provided for electric retail competition and transition asset recovery.
2008 Proposed Settlement Agreement		Proposed Settlement Agreement filed with the ACC in TEP’s 2007/2008 rate case proceeding.
Springerville		Springerville Generating Station.
Springerville Coal Handling Facilities Leases		Leveraged lease arrangements relating to the coal handling facilities serving Springerville.
Springerville Common Facilities		Facilities at Springerville used in common with Springerville Unit 1 and Springerville Unit 2.
Springerville Common Facilities Leases		Leveraged lease arrangements relating to an undivided one-half interest in certain Springerville Common Facilities.
Springerville Unit 1		Unit 1 of the Springerville Generating Station.
Springerville Unit 1 Leases		Leveraged lease arrangement relating to Springerville Unit 1 and an undivided one-half interest in certain Springerville Common Facilities.
Springerville Unit 2		Unit 2 of the Springerville Generating Station.
Springerville Unit 3		Unit 3 of the Springerville Generating Station.
Springerville Unit 4		Unit 4 of the Springerville Generating Station.
SRP		Salt River Project Agricultural Improvement and Power District.
Sundt		H. Wilson Sundt Generating Station.
Sundt Unit 4		Unit 4 of the H. Wilson Sundt Generating Station.
TEP		Tucson Electric Power Company, the principal subsidiary of UniSource Energy.
TEP Credit Agreement		Amended and Restated Credit Agreement between TEP and a syndicate of Banks, dated as of August 11, 2006.
TEP Letter of Credit Facility		Letter of credit facility between TEP and a syndicate of Banks, dated as of April 30,2008.
TEP Revolving Credit Facility		Revolving credit facility under the TEP Credit Agreement.
Therm		A unit of heating value equivalent to 100,000 British thermal units (Btu).
TOU		Time of use.
TRA		Transition Recovery Asset, a $450 million regulatory asset established in TEP’s 1999 Settlement Agreement to be fully recovered by December 31, 2008.
Tri-State		Tri-State Generation and Transmission Association.
UED		UniSource Energy Development Company, a wholly-owned subsidiary of UniSource Energy, which engages in developing generation resources and other project development services and related activities.
UES		UniSource Energy Services, Inc., an intermediate holding company established to own the operating companies (UNS Gas and UNS Electric) which acquired the Citizens’ Arizona gas and electric utility assets in 2003.
UniSource Credit Agreement		Amended and Restated Credit Agreement between UniSource Energy and a syndicate of banks, dated as of August 11, 2006.
UniSource Energy		UniSource Energy Corporation.
UNS Electric		UNS Electric, Inc., a wholly-owned subsidiary of UES, which acquired the Citizens’ Arizona electric utility assets in 2003.
UNS Gas		UNS Gas, Inc., a wholly-owned subsidiary of UES, which acquired the Citizens’ Arizona gas utility assets in 2003.
UNS Gas/UNS Electric Revolver		Revolving credit facility under the Amended and Restated Credit Agreement among UNS Gas and UNS Electric as borrowers, UES as guarantor, and a syndicate of banks, dated as of August 11, 2006.

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of
UniSource Energy Corporation:

We have reviewed the accompanying condensed consolidated balance sheet of UniSource Energy Corporation and its subsidiaries (the Company) as of September 30, 2008, and the related condensed consolidated statements of income (loss) for each of the three-month and nine-month periods ended September 30, 2008 and 2007, the condensed consolidated statement of changes in stockholders’ equity and comprehensive income (loss) for the nine-month period ended September 30, 2008, and the condensed consolidated statements of cash flows for the nine-month periods ended September 30, 2008 and 2007. These interim financial statements are the responsibility of the Company’s management.

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

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

We previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2007, and the related consolidated statements of income, of cash flows, of capitalization, and of changes in stockholders’ equity and comprehensive income for the year then ended (not presented herein), and in our report dated February 26, 2008, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2007, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.

PricewaterhouseCoopers LLP
Chicago, Illinois
November 7, 2008

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholder of
Tucson Electric Power Company:

We have reviewed the accompanying condensed consolidated balance sheet of Tucson Electric Power Company and its subsidiaries (the Company) as of September 30, 2008, and the related condensed consolidated statements of income (loss) for each of the three-month and nine-month periods ended September 30, 2008 and 2007, the condensed consolidated statement of changes in stockholder’s equity and comprehensive income (loss) for the nine-month period ended September 30, 2008, and the condensed consolidated statements of cash flows for the nine-month periods ended September 30, 2008 and 2007. These interim financial statements are the responsibility of the Company’s management.

We previously audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2007, and the related consolidated statements of income, of cash flows, of capitalization, and of changes in stockholder’s equity and comprehensive income for the year then ended (not present herein), and in our report dated February 26, 2008, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2007, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.

PricewaterhouseCoopers LLP
Chicago, Illinois
November 7, 2008

PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

UNISOURCE ENERGY CORPORATION

COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)


Three Months Ended							Nine Months Ended
September 30,							September 30,
2008			2007				2008			2007
(Unaudited)							(Unaudited)
-Thousands of Dollars-							- Thousands of Dollars -
(Except Per Share Amounts)							(Except Per Share Amounts)
						Operating Revenues
$	321,596		$	320,238		Electric Retail Sales	$	768,433		$	765,450
	(29,517	)		—		CTC Revenue Subject to Refund		(44,415	)		—

	292,079			320,238		Net Electric Retail Sales		724,018			765,450
	57,279			46,225		Electric Wholesale Sales		187,104			139,515
	19,739			15,967		Gas Revenue		114,786			100,927
	18,755			15,774		Other Revenues		52,400			39,925

	387,852			398,204		Total Operating Revenues		1,078,308			1,045,817


						Operating Expenses
	110,797			90,135		Fuel		253,067			223,423
	134,827			104,428		Purchased Energy		356,703			271,464
	80,365			60,226		Other Operations and Maintenance		226,016			194,346
	36,762			34,513		Depreciation and Amortization		109,196			103,494
	—			25,739		Amortization of Transition Recovery Asset		23,945			59,944
	10,078			11,555		Taxes Other Than Income Taxes		35,198			36,208

	372,829			326,596		Total Operating Expenses		1,004,125			888,879

	15,023			71,608		Operating Income		74,183			156,938


						Other Income (Deductions)
	2,520			3,756		Interest Income		8,724			12,656
	1,069			1,811		Other Income		6,267			7,455
	(2,837	)		(2,291	)	Other Expense		(5,719	)		(4,542	)

	752			3,276		Total Other Income (Deductions)		9,272			15,569


						Interest Expense
	18,182			18,468		Long-Term Debt		53,603			54,733
	14,303			16,112		Interest on Capital Leases		42,969			48,390
	(349	)		1,355		Other Interest Expense		1,375			4,767
	(1,304	)		(2,199	)	Interest Capitalized		(4,480	)		(5,228	)

	30,832			33,736		Total Interest Expense		93,467			102,662


	(15,057	)		41,148		Income (Loss) before Income Taxes		(10,012	)		69,845
	(4,018	)		15,731		Income Tax Expense (Benefit)		(1,106	)		27,678


$	(11,039	)	$	25,417		Net Income (Loss)	$	(8,906	)	$	42,167


	35,677			35,514		Weighted-average Shares of Common Stock Outstanding (000)		35,616			35,469


$	(0.31	)	$	0.72		Basic Earnings (Loss) per Share	$	(0.25	)	$	1.19


$	(0.31	)	$	0.66		Diluted Earnings (Loss) per Share	$	(0.25	)	$	1.13


$	0.240		$	0.225		Dividends Declared per Share	$	0.720		$	0.675

See Notes to Condensed Consolidated Financial Statements.

UNISOURCE ENERGY CORPORATION

COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


	Nine Months Ended
	September 30,
	2008			2007
	(Unaudited)
	- Thousands of Dollars -
Cash Flows from Operating Activities
Cash Receipts from Electric Retail Sales	$	803,707		$	793,437
Cash Receipts from Electric Wholesale Sales		272,558			226,429
Cash Receipts from Gas Sales		147,754			135,886
Cash Receipts from Operating Springerville Unit 3		41,709			28,440
Interest Received		17,069			18,349
Performance Deposits Receipts		27,904			7,554
Sale of Excess Emission Allowances		1,494			9,987
Income Tax Refunds Received		19,626			1,016
Other Cash Receipts		11,884			8,529
Purchased Energy Costs Paid		(461,724	)		(354,410	)
Fuel Costs Paid		(223,273	)		(214,098	)
Wages Paid, Net of Amounts Capitalized		(84,543	)		(83,332	)
Payment of Other Operations and Maintenance Costs		(140,773	)		(126,019	)
Capital Lease Interest Paid		(43,278	)		(53,482	)
Taxes Paid Other than Income Taxes, Net of Amounts Capitalized		(106,327	)		(102,527	)
Interest Paid, Net of Amounts Capitalized		(50,252	)		(59,186	)
Income Taxes Paid		(9,900	)		(20,923	)
Performance Deposit Payments		(31,340	)		(7,900	)
Excess Tax Benefit from Stock Options Exercised		(612	)		(443	)
Other Cash Payments		(4,347	)		(3,770	)

Net Cash Flows — Operating Activities		187,336			203,537


Cash Flows from Investing Activities
Capital Expenditures		(255,798	)		(181,894	)
Deposit to Trustee for Repayment of Collateral Trust Bond		(133,111	)		—
Proceeds from Investment in Springerville Lease Debt		24,918			27,732
Proceeds from the Sale of Land		538			2,524
Return of Investment from Millennium Energy Business		839			12
Other Cash Receipts		4,518			1,951
Investment in and Loans to Equity Investees		(288	)		(632	)
Other Cash Payments		(706	)		(2,864	)

Net Cash Flows — Investing Activities		(359,090	)		(153,171	)


Cash Flows from Financing Activities
Proceeds from Issuance of Long-Term Debt		320,745			—
Proceeds from Borrowings under Revolving Credit Facilities		231,000			160,000
Payments on Borrowings under Revolving Credit Facilities		(227,000	)		(159,000	)
Payments on Capital Lease Obligations		(74,292	)		(71,533	)
Common Stock Dividends Paid		(25,521	)		(23,829	)
Repayments of Long-Term Debt		(74,500	)		(4,500	)
Payment of Debt Issue/Retirement Costs		(3,561	)		(429	)
Proceeds from Stock Options Exercised		1,910			1,689
Excess Tax Benefit from Stock Options Exercised		612			443
Other Cash Receipts		5,419			7,228
Other Cash Payments		(2,866	)		(5,452	)

Net Cash Flows — Financing Activities		151,946			(95,383	)


Net Decrease in Cash and Cash Equivalents		(19,808	)		(45,017	)
Cash and Cash Equivalents, Beginning of Year		90,373			104,241

Cash and Cash Equivalents, End of Period	$	70,565		$	59,224


Non-Cash Financing Activity — Repayment of Collateral Trust Bond	$	(128,300	)	$	—

See Note 13 for supplemental cash flow information.

See Notes to Condensed Consolidated Financial Statements.

UNISOURCE ENERGY CORPORATION

COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS


	September 30,			December 31,
	2008			2007
	(Unaudited)
	- Thousands of Dollars -
ASSETS
Utility Plant
Plant in Service	$	3,747,588		$	3,565,735
Utility Plant under Capital Leases		702,337			702,337
Construction Work in Progress		220,424			195,105

Total Utility Plant		4,670,349			4,463,177
Less Accumulated Depreciation and Amortization		(1,588,728	)		(1,534,424	)
Less Accumulated Amortization of Capital Lease Assets		(540,593	)		(521,458	)

Total Utility Plant — Net		2,541,028			2,407,295


Investments and Other Property
Investments in Lease Debt and Equity		126,911			152,544
Other		64,527			70,677

Total Investments and Other Property		191,438			223,221


Current Assets
Cash and Cash Equivalents		70,565			90,373
Accounts Receivable — Retail and Other		85,761			67,885
Accounts Receivable — Wholesale Sales		43,214			46,316
Unbilled Accounts Receivable		58,179			62,101
Allowance for Doubtful Accounts		(19,090	)		(18,446	)
Materials and Fuel		90,891			82,433
Regulatory Assets		17,085			10,262
Energy Contracts — Derivative Assets		13,993			5,489
Deferred Income Taxes — Current		59,708			60,055
Income Tax Receivable		12,995			—
Interest Receivable on Capital Lease Debt Investment		2,245			6,033
Interest Receivable — Other		88			3,417
Other		24,789			14,322

Total Current Assets		460,423			430,240


Regulatory and Other Assets
Income Taxes Recoverable Through Future Revenues		27,102			30,009
Regulatory Assets — Other		40,965			37,313
Energy Contracts — Derivative Assets		6,037			8,339
Regulatory Assets — Transition Recovery Asset		—			23,944
Other Assets		24,841			25,355

Total Regulatory and Other Assets		98,945			124,960


Total Assets	$	3,291,834		$	3,185,716

See Notes to Condensed Consolidated Financial Statements.

(Continued)

UNISOURCE ENERGY CORPORATION

COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS


	September 30,			December 31,
	2008			2007
	(Unaudited)
	- Thousands of Dollars -
CAPITALIZATION AND OTHER LIABILITIES
Capitalization
Common Stock	$	706,412		$	702,368
Accumulated Deficit		(35,655	)		(628	)
Accumulated Other Comprehensive Income (Loss)		(17,531	)		(11,665	)

Common Stock Equity		653,226			690,075
Capital Lease Obligations		511,422			530,973
Long-Term Debt		1,314,115			993,870

Total Capitalization		2,478,763			2,214,918


Current Liabilities
Current Obligations under Capital Leases		18,328			58,599
Borrowing Under Revolving Credit Facilities		10,000			10,000
Current Maturities of Long-Term Debt		6,000			204,300
Accounts Payable		63,380			72,003
Accounts Payable — Purchased Power		43,397			50,684
Interest Accrued		25,508			48,091
Accrued Taxes Other than Income Taxes		49,254			36,775
Accrued Employee Expenses		21,787			24,585
Customer Deposits		21,811			21,425
Regulatory Liabilities — Deferred CTC Revenue		44,662			—
Regulatory Liabilities — Over-Recovered Purchased Energy Costs		9,246			13,084
Regulatory Liabilities — Other		6,255			3,436
Energy Contracts — Derivative Liabilities		30,954			3,193
Other		1,179			1,506

Total Current Liabilities		351,761			547,681


Deferred Credits and Other Liabilities
Deferred Income Taxes — Noncurrent		159,509			149,730
Pension and Other Post-Retirement Benefits		72,719			76,407
Regulatory Liabilities — Net Cost of Removal for Interim Retirements		121,483			106,695
Regulatory Liabilities — Derivatives Instruments		—			6,426
Regulatory Liabilities — Over-Recovered Purchased Power Costs		—			9,295
Customer Advances for Construction		31,385			28,798
Energy Contracts — Derivative Liabilities		20,505			4,930
Other		55,709			40,836

Total Deferred Credits and Other Liabilities		461,310			423,117


Commitments and Contingencies (Note 7)

Total Capitalization and Other Liabilities	$	3,291,834		$	3,185,716

See Notes to Condensed Consolidated Financial Statements.

(Concluded)

UNISOURCE ENERGY CORPORATION

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)


								Accumulated
	Common							Other			Total
	Shares		Common		Accumulated			Comprehensive			Stockholders’
	Issued*		Stock		Deficit			Income (Loss)			Equity
	(Unaudited)
	- Thousands of Dollars -

Balances at December 31, 2007		35,315	$	702,368	$	(628	)	$	(11,665	)	$	690,075


Impact of Change in Pension Plan Measurement Date						(603	)					(603	)


Comprehensive Income (Loss):
2008 Year-to-Date Net Loss						(8,906	)					(8,906	)

Unrealized Loss on Cash Flow Hedges (net of $3,178 income taxes)									(4,848	)		(4,848	)

Reclassification of Unrealized Gain on Cash Flow Hedges to Net Income (net of $578 income taxes)									(882	)		(882	)

Employee Benefit Obligations
Amortization of net actuarial loss and prior service credit included in net periodic benefit cost (net of $89 income taxes)									(136	)		(136	)


Total Comprehensive Income (Loss)												(14,772	)


Dividends Declared						(25,518	)					(25,518	)
Shares Issued under Stock Compensation Plans		22
Shares Issued for Stock Options		116		1,910								1,910
Tax Benefit Realized from Stock Options Exercised				612								612
Other				1,522								1,522


Balances at September 30, 2008		35,453	$	706,412	$	(35,655	)	$	(17,531	)	$	653,226


*		UniSource Energy has 75 million authorized shares of Common Stock.

See Notes to Condensed Consolidated Financial Statements.

TUCSON ELECTRIC POWER COMPANY

COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)


Three Months Ended							Nine Months Ended
September 30,							September 30,
2008			2007				2008			2007
(Unaudited)							(Unaudited)
- Thousands of Dollars -							- Thousands of Dollars -
						Operating Revenues
$	259,913		$	266,466		Electric Retail Sales	$	627,135		$	635,818
	(29,517	)		—		CTC Revenue Subject to Refund		(44,415	)		—

	230,396			266,466		Net Electric Retail Sales		582,720			635,818
	72,896			46,120		Electric Wholesale Sales		207,791			139,337
	20,020			16,255		Other Revenues		55,544			41,686

	323,312			328,841		Total Operating Revenues		846,055			816,841


						Operating Expenses
	107,228			90,135		Fuel		247,927			223,423
	100,418			58,094		Purchased Power		211,194			115,111
	68,935			47,845		Other Operations and Maintenance		193,469			159,569
	31,201			29,392		Depreciation and Amortization		93,198			88,033
	—			25,739		Amortization of Transition Recovery Asset		23,945			59,944
	8,079			9,616		Taxes Other Than Income Taxes		29,143			30,222

	315,861			260,821		Total Operating Expenses		798,876			676,302

	7,451			68,020		Operating Income		47,179			140,539


						Other Income (Deductions)
	2,238			3,092		Interest Income		7,704			10,496
	927			1,160		Other Income		4,943			3,913
	(2,526	)		(2,048	)	Other Expense		(3,255	)		(3,725	)

	639			2,204		Total Other Income (Deductions)		9,392			10,684


						Interest Expense
	12,317			12,651		Long-Term Debt		36,654			37,766
	14,298			16,105		Interest on Capital Leases		42,953			48,371
	(457	)		1,062		Other Interest Expense		1,012			4,020
	(1,279	)		(1,397	)	Interest Capitalized		(3,632	)		(3,264	)

	24,879			28,421		Total Interest Expense		76,987			86,893


	(16,789	)		41,803		Income (Loss) Before Income Taxes		(20,416	)		64,330
	(4,552	)		15,844		Income Tax Expense (Benefit)		(5,081	)		25,279


$	(12,237	)	$	25,959		Net Income (Loss)	$	(15,335	)	$	39,051

See Notes to Condensed Consolidated Financial Statements.

TUCSON ELECTRIC POWER COMPANY

COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


	Nine Months Ended
	September 30,
	2008			2007
	(Unaudited)
	- Thousands of Dollars -
Cash Flows from Operating Activities
Cash Receipts from Electric Retail Sales	$	658,958		$	658,623
Cash Receipts from Electric Wholesale Sales		291,876			226,429
Cash Receipts from Operating Springerville Unit 3		41,709			28,440
Income Tax Refunds Received		18,028			—
Interest Received		15,763			16,006
Reimbursement of Affiliate Charges		16,351			—
Sale of Excess Emission Allowances		1,494			9,987
Performance Deposits Receipts		10,150			—
Other Cash Receipts		6,762			5,888
Purchased Power Costs Paid		(287,785	)		(190,071	)
Fuel Costs Paid		(218,664	)		(214,099	)
Payment of Other Operations and Maintenance Costs		(135,053	)		(116,657	)
Wages Paid, Net of Amounts Capitalized		(66,950	)		(65,818	)
Capital Lease Interest Paid		(43,260	)		(53,464	)
Taxes Other than Income Taxes Paid, Net of Amounts Capitalized		(79,006	)		(76,583	)
Interest Paid, Net of Amounts Capitalized		(30,585	)		(39,159	)
Income Taxes Paid		—			(23,609	)
Performance Deposits Payments		(10,150	)		—
Other Cash Payments		(3,005	)		(2,769	)

Net Cash Flows — Operating Activities		186,633			163,144


Cash Flows from Investing Activities
Capital Expenditures		(209,312	)		(123,352	)
Deposit to Trustee for Repayment of Collateral Trust Bond		(133,111	)		—
Proceeds from Investment in Springerville Lease Debt		24,918			27,732
Proceeds from Sale of Land		537			642
Other Cash Payments		(706	)		(2,444	)
Other Cash Receipts		4,518			—

Net Cash Flows — Investing Activities		(313,156	)		(97,422	)


Cash Flows from Financing Activities
Proceeds from Issuance of Long-Term Debt		220,745			—
Proceeds from Borrowings under Revolving Credit Facility		160,000			120,000
Payments on Borrowings under Revolving Credit Facility		(160,000	)		(134,000	)
Payments on Capital Lease Obligations		(74,228	)		(71,464	)
Repayments of Long-Term Debt		(10,000	)		—
Payment of Debt Issue/Retirement Costs		(2,942	)		(415	)
Other Cash Receipts		1,012			11,206
Other Cash Payments		(1,221	)		(783	)

Net Cash Flows — Financing Activities		133,366			(75,456	)


Net Increase (Decrease) in Cash and Cash Equivalents		6,843			(9,734	)
Cash and Cash Equivalents, Beginning of Year		26,610			19,711

Cash and Cash Equivalents, End of Period	$	33,453		$	9,977


Non-Cash Financing Activity — Repayment of Collateral Trust Bond	$	(128,300	)	$	—

See Note 13 for supplemental cash flow information.

See Notes to Condensed Consolidated Financial Statements.

TUCSON ELECTRIC POWER COMPANY

COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS


	September 30,			December 31,
	2008			2007
	(Unaudited)
	- Thousands of Dollars -
ASSETS
Utility Plant
Plant in Service	$	3,237,216		$	3,143,823
Utility Plant under Capital Leases		701,631			701,631
Construction Work in Progress		198,767			123,833

Total Utility Plant		4,137,614			3,969,287
Less Accumulated Depreciation and Amortization		(1,541,664	)		(1,490,724	)
Less Accumulated Amortization of Capital Lease Assets		(540,124	)		(521,057	)

Total Utility Plant — Net		2,055,826			1,957,506


Investments and Other Property
Investments in Lease Debt and Equity		126,911			152,544
Other		31,583			35,460

Total Investments and Other Property		158,494			188,004


Current Assets
Cash and Cash Equivalents		33,453			26,610
Accounts Receivable — Wholesale Sales		43,122			46,316
Accounts Receivable — Retail and Other		64,391			44,431
Unbilled Accounts Receivable		43,294			35,941
Allowance for Doubtful Accounts		(16,940	)		(16,538	)
Intercompany Accounts Receivable		10,889			8,740
Income Tax Receivable		4,772			8,070
Materials and Fuel Inventory		80,220			72,732
Regulatory Assets		9,401			9,554
Deferred Income Taxes — Current		56,712			59,157
Interest Receivable on Capital Lease		2,245			6,033
Interest Receivable — Current		—			3,350
Energy Contracts — Derivative Instruments		13,494			2,036
Other		19,584			13,062

Total Current Assets		364,637			319,494


Regulatory and Other Assets
Income Taxes Recoverable Through Future Revenues		27,102			30,009
Regulatory Assets — Other		32,859			34,123
Energy Contracts — Derivative Instruments		4,200			492
Regulatory Assets — Transition Recovery Asset		—			23,945
Other Assets		19,018			19,463

Total Regulatory and Other Assets		83,179			108,032


Total Assets	$	2,662,136		$	2,573,036

See Notes to Condensed Consolidated Financial Statements.

(Continued)

TUCSON ELECTRIC POWER COMPANY

COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS


	September 30,			December 31,
	2008			2007
	(Unaudited)
	- Thousands of Dollars -
CAPITALIZATION AND OTHER LIABILITIES
Capitalization
Common Stock	$	813,971		$	813,971
Capital Stock Expense		(6,357	)		(6,357	)
Accumulated Deficit		(234,349	)		(218,488	)
Accumulated Other Comprehensive Income (Loss)		(11,689	)		(11,777	)

Common Stock Equity		561,576			577,349
Capital Lease Obligations		511,244			530,714
Long-Term Debt		903,615			682,870

Total Capitalization		1,976,435			1,790,933


Current Liabilities
Current Obligations under Capital Leases		18,231			58,502
Current Maturities of Long-Term Debt		—			138,300
Borrowing Under Revolving Credit Facility		10,000			10,000
Accounts Payable		55,345			64,664
Accounts Payable — Purchased Power		31,185			22,935
Intercompany Accounts Payable		8,683			4,512
Interest Accrued		22,877			41,394
Accrued Taxes Other than Income Taxes		40,268			28,690
Accrued Employee Expenses		19,560			22,557
Energy Contracts — Derivative Instruments		16,642			2,460
Regulatory Liabilities — Deferred CTC Revenue		44,662			—
Regulatory Liabilities — Other		5,258			—
Other		15,884			15,533

Total Current Liabilities		288,595			409,547


Deferred Credits and Other Liabilities
Deferred Income Taxes — Noncurrent		164,254			163,834
Regulatory Liabilities — Net Cost of Removal for Interim Retirements		93,444			87,311
Energy Contracts — Derivative Instruments		9,166			3,278
Pension and Other Post-Retirement Benefits		69,594			72,755
Other		60,648			45,378

Total Deferred Credits and Other Liabilities		397,106			372,556


Commitments and Contingencies (Note 7)

Total Capitalization and Other Liabilities	$	2,662,136		$	2,573,036

See Notes to Condensed Consolidated Financial Statements.

(Concluded)

TUCSON ELECTRIC POWER COMPANY

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER’S EQUITY AND COMPREHENSIVE INCOME (LOSS)


									Accumulated
			Capital						Other			Total
	Common		Stock			Accumulated			Comprehensive			Stockholder’s
	Stock		Expense			Deficit			Income (Loss)			Equity
	(Unaudited)
	- Thousands of Dollars -
Balances at December 31, 2007	$	813,971	$	(6,357	)	$	(218,488	)	$	(11,777	)	$	577,349


Impact of Change in Pension Plan Measurement Date							(526	)					(526	)


Comprehensive Income (Loss):
2008 Year-to-Date Net Loss							(15,335	)					(15,335	)

Unrealized Gain on Cash Flow Hedges (net of $728 income taxes)										1,110			1,110

Reclassification of Unrealized Gains on Cash Flow Hedges to Net Income (net of $582 income taxes)										(887	)		(887	)

Employee Benefit Obligations
Amortization of net actuarial loss and prior service credit included in net periodic benefit cost (net of $89 income taxes)										(135	)		(135	)


Total Comprehensive Income (Loss)													(15,247	)


Balances at September 30, 2008	$	813,971	$	(6,357	)	$	(234,349	)	$	(11,689	)	$	561,576

See Notes to Condensed Consolidated Financial Statements.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — Unaudited

NOTE 1. NATURE OF OPERATIONS AND BASIS OF ACCOUNTING PRESENTATION

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

TEP, a regulated public utility, is UniSource Energy’s largest operating subsidiary and represented approximately 81% of UniSource Energy’s assets as of September 30, 2008. TEP generates, transmits and distributes electricity to approximately 399,000 retail electric customers in a 1,155 square mile area in Southern Arizona. TEP also sells electricity to other utilities and power marketing entities primarily located in the Western U.S. In addition, TEP operates Springerville Unit 3 on behalf of Tri-State Generation and Transmission Association, Inc. (Tri-State).

UES holds the common stock of UNS Gas, Inc. (UNS Gas) and UNS Electric, Inc. (UNS Electric). UNS Gas is a gas distribution company with 144,000 retail customers in Mohave, Yavapai, Coconino, and Navajo counties in Northern Arizona, as well as Santa Cruz County in Southeast Arizona. UNS Electric is an electric transmission and distribution company with approximately 90,000 retail customers in Mohave and Santa Cruz counties.

Millennium holds investments in unregulated businesses.

In May 2008, UED completed the development of the Black Mountain Generating Station (BMGS), a 90 MW gas turbine generating facility in Northern Arizona and, through a power sale agreement (PPA), is providing energy to UNS Electric.

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

The accompanying quarterly financial statements of UniSource Energy and TEP are unaudited but reflect all normal recurring accruals and other adjustments which we believe are necessary for a fair presentation of the results for the interim periods presented. These financial statements are presented in accordance with the Securities and Exchange Commission’s (SEC) interim reporting requirements which do not include all the disclosures required by accounting principles generally accepted in the United States of America (GAAP) for audited annual financial statements. The year-end condensed balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP for audited annual financial statements. This quarterly report should be reviewed in conjunction with UniSource Energy and TEP’s 2007 Annual Report on Form 10-K.

Weather, among other factors, causes seasonal fluctuations in TEP, UNS Gas and UNS Electric’s sales; therefore, quarterly results are not indicative of annual operating results.

To be comparable with the 2008 presentation, UniSource Energy and TEP reclassified in the prior year Statements of Income less than $0.5 million, from Other Income to Interest Income.

In June 2008, UniSource Energy recorded a pre-tax charge of approximately $2 million ($1.2 million after-tax) related to an investment impairment for Valley Ventures III LP, a Millennium investment, $1 million ($0.6 million after-tax) of which should have been recorded prior to 2008.

In September 2008, TEP recorded an additional tax expense of $1 million related to a determination that certain accrued tax penalty payments will not be deductible for tax purposes under IRS regulations.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

NOTE 2. REGULATORY MATTERS

ACCOUNTING FOR RATE REGULATION

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

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

	•		an independent regulator sets rates;

	•		the regulator sets the rates to recover the specific costs of providing service; and

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

TEP RATES AND REGULATION

TEP Rate Proceeding

Beginning in May 2005, TEP filed a series of pleadings requesting the ACC to resolve the uncertainty surrounding the methodology that will be applied to determine TEP’s rates for generation service after 2008. TEP filed the pleadings in response to the Arizona Court of Appeals’ ruling related to retail competition and market pricing and a lack of agreement by a number of participants in TEP’s rate proceedings on rate methodology after 2008. TEP believes that the 1999 Settlement Agreement contemplated market based rates for generation service after 2008; other participants, including ACC Staff, disagree and have stated that the 1999 Settlement Agreement does not control how TEP’s rates for generation service will be established after 2008.

TEP Rate Proposals

In accordance with an ACC order, TEP filed three rate proposal methodologies (market, hybrid and cost-of-service) with the ACC in July 2007, to establish new rates for TEP when the existing rate increase moratorium of the 1999 Settlement Agreement is lifted on January 1, 2009. The estimated average rate increases under the three methodologies ranged from 15% to 23%.

TEP 2008 Proposed Settlement Agreement

In May 2008, TEP filed a settlement agreement (TEP 2008 Proposed Settlement Agreement) with the ACC. Hearings before an ACC administrative law judge (ALJ) concluded on July 16, 2008. Reply briefs were filed by the participants in TEP’s rate case proceeding on August 29, 2008. On October 28, 2008, the ALJ issued an opinion that recommends that the ACC adopt the 2008 Proposed Settlement Agreement, with new rates effective on December 1, 2008. The opinion issued by the ALJ will be subject to ACC approval. The ACC scheduled a special open meeting on November 25, 2008 to deliberate and vote on the ALJ recommended opinion and order. TEP cannot predict the outcome of the TEP 2008 Proposed Settlement Agreement proceedings.

The TEP 2008 Proposed Settlement Agreement provides for a cost of service rate methodology for TEP’s generation assets; a base rate increase of 6% over TEP’s current retail rates; a fuel rate included in base rates of 2.9 cents per kilowatt-hour (kWh); a PPFAC effective January 1, 2009; a base rate moratorium through January 1, 2013; and a waiver of any claims under the 1999 Settlement Agreement.

Since the TEP 2008 Proposed Settlement Agreement provides for a cost of service methodology, TEP is analyzing the implications of reapplying FAS 71 for its generation operations.

Transition Recovery Asset and Provision for Rate Refunds

In May 2008, TEP fully amortized the remaining Transition Recovery Asset (TRA) balance, as costs were fully recovered through rates. At December 31, 2007, the TRA balance was $24 million.

In May 2007, the ACC ordered that TEP’s current Fixed CTC revenue shall remain at their current level until the effective date of a final order in the TEP 2008 Proposed Settlement Agreement proceeding. The cash collected in excess of the TRA along with accrued interest is subject to refund to the ratepayer.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

As of September 30, 2008, TEP had collected $44 million of true-up revenues and recorded a $44 million offset for CTC revenue subject to refund against its Electric Retail Sales in 2008. TEP reflected the CTC revenue subject to refund on its balance sheet as Regulatory Liabilities — Deferred CTC Revenue. The ALJ opinion recommends that the ACC credit all of the true-up revenues collected through November 30, 2008, to customers through the PPFAC. TEP will continue to record the true-up revenues and an offset for CTC revenue subject to refund until the ACC issues a final order.

Renewable Energy Standard Tariff (REST)

The ACC approved a REST surcharge for TEP, effective June 1, 2008, to allow TEP to recover the cost of qualified renewable expenditures, such as payments to customers who have renewable energy resources or the incremental cost of renewable power generated or purchased by TEP. Any surcharge collected in excess of qualified renewable expenditures will be reflected in the financial statements as a current regulatory liability. Conversely, qualified renewable expenditures in excess of the REST surcharge will be reflected as a current regulatory asset. At September 30, 2008, TEP had a current regulatory liability of $5 million.

The TEP 2008 Proposed Settlement Agreement includes a REST adjustor mechanism which would allow TEP to file an application with the ACC to apply any shortage or surplus in the prior year’s program expenses to the subsequent year’s REST surcharge. The ALJ opinion recommends that the ACC approves the adjustor mechanism.

Future Implications of Discontinuing Application of FAS 71

TEP continues to apply FAS 71 to its regulated operations, which include the transmission and distribution portions of its business. TEP regularly assesses whether it can continue to apply FAS 71 to these operations. If TEP stopped applying FAS 71 to its remaining regulated operations, it would write-off the related balances of its regulatory assets as an expense and recognize its regulatory liabilities as income on its income statement. Based on the regulatory asset balances, net of regulatory liabilities, at September 30, 2008, if TEP had stopped applying FAS 71 to its remaining regulated operations, it would have recorded an extraordinary after-tax gain of approximately $45 million. While regulatory orders and market conditions may affect cash flows, TEP’s cash flows would not be affected if it stopped applying FAS 71.

UNS GAS RATES AND REGULATION

2008 General Rate Case Filing

On November 6, 2008, UNS Gas filed a general rate case (on a cost of service basis) with the ACC requesting a total rate increase of 6% to cover a revenue deficiency of $10 million. The case uses a June 30, 2008 test year. UNS Gas expects the ACC to rule on its rate case in 2009.

Purchase Gas Adjustor (PGA) Mechanism

UNS Gas’ retail rates include a PGA mechanism intended to address the volatility of natural gas prices and allow UNS Gas to recover its actual commodity costs, including transportation, through a price adjustor. All purchased gas commodity costs, including transportation, increase the PGA bank, a balancing account. UNS Gas recovers these costs or returns amounts over-collected from/to ratepayers through a PGA rate. The PGA rate includes the following two components:

(1)

The PGA factor, computed monthly, is a calculation of the twelve-month rolling weighted average gas cost, and automatically adjusts monthly, subject to limitations on how much the price per therm may change in a twelve-month period. Effective December 2007, the ACC increased the annual cap on the maximum increase in the PGA factor from $0.10 per therm to $0.15 per therm in a twelve-month period.

	(2)		At any time UNS Gas’ PGA bank balance is under-recovered, UNS Gas may request a PGA surcharge with the goal of collecting the amount deferred from customers over a period deemed appropriate by the ACC. When the PGA bank balance reaches an over-collected balance of $10 million on a billed basis, UNS Gas is required to request a PGA surcredit with the goal of returning the over-collected balance to customers over a period deemed appropriate by the ACC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

The PGA surcharge in 2007 was $0.05 cents per therm through April 2007. In September 2007, the ACC approved a $0.04 cent per therm PGA surcredit, effective October 2007 through April 2008. Since May 2008, there has been no surcharge or surcredit in effect.

Based on current projections of gas prices, UNS Gas believes that the current PGA rates will allow it to timely recover its gas costs. However, changes in the market price for gas, sales volumes and surcharge amount could significantly change the PGA bank balance in the future.

At September 30, 2008, UNS Gas had over recovered its costs by $4 million on an accrual (GAAP) basis, of which $2 million was on a billed basis. At December 31, 2007, UNS Gas had over recovered its costs by $13 million on an accrual (GAAP) basis of which $3 million was on a billed basis. The balance is shown on the balance sheet as Regulatory Liabilities — Over-Recovered Purchased Energy Costs.

Future Implications of Discontinuing Application of FAS 71

UNS Gas regularly assesses whether it can continue to apply FAS 71 to its regulated operations. If UNS Gas stopped applying FAS 71, UNS Gas would write-off the related balance of its regulatory assets as an expense and write-off its regulatory liabilities as income on its income statement. Based on the regulatory asset and liability balances, if UNS Gas had stopped applying FAS 71, UNS Gas would have recorded an extraordinary after-tax gain of $13 million at September 30, 2008. While regulatory orders and market conditions may affect cash flows, UNS Gas’ cash flows would not be affected if it stopped applying FAS 71.

UNS ELECTRIC RATES AND REGULATION

2008 Rate Order

In the May 2008 rate order, the ACC approved a rate increase of 2.5% ($4 million) compared with UNS Electric’s request of 5.5% ($9 million). New rates went into effect in June 2008. The order also included a 9% return on an original rate base cost of $131 million. UNS Electric had requested a 9.9% return on an original rate base cost of $141 million.

As a result of the May 2008 rate order limiting recovery of deferred rate case costs, UNS Electric expensed $0.3 million of the $0.6 million deferred costs in May 2008.

Also in June 2008, to comply with ACC expectations, UNS Electric reclassified $7 million of Net Cost of Removal for Interim Retirements from Accumulated Depreciation to a regulatory liability.

Purchased Power and Fuel Adjustment Clause (PPFAC)

UNS Electric’s retail rates include a PPFAC, which allows for a separate surcharge or surcredit to the base rate for delivered purchased power to collect or return under- or over-recovery of costs. Allowable PPFAC costs include fuel, purchased power (less proceeds from most wholesale sales) and transmission costs.

As part of the May 2008 ACC rate order, a new PPFAC rate of approximately $0.087 per kWh took effect on June 1, 2008. The PPFAC mechanism has a forward component and a true-up component. The forward component of the PPFAC rate is based on forecasted fuel and purchased power costs. The true-up component reconciles actual fuel and purchased power costs with the amounts collected in the preceding PPFAC year and any amounts to be refunded/collected from customers in the coming year’s PPFAC rate. The true-up component is updated on June 1 of each year, beginning June 1, 2009. The retail rates prior to June 2008 included a charge for fuel and purchased power of approximately $0.07 per kWh (base rate recovery of $0.052 per kWh and a transmission surcharge of $0.018).


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

At September 30, 2008, UNS Electric had over recovered its purchased power by $5 million on an accrual (GAAP) basis, of which $2 million was under-recovered on a billed basis. The PPFAC balance is shown in Current Liabilities as Regulatory Liabilities — Over-Recovered Purchased Energy Costs. At December 31, 2007, UNS Electric had over recovered its purchased power by $9 million on an accrual (GAAP) basis of which $4 million was on a billed basis and the balance is shown as a noncurrent liability in Deferred Credits and Other Liabilities — Over-Recovered Purchased Power Costs.

Purchased Power Agreement

As part of its rate case filing, UNS Electric requested that the ACC approve a proposed purchase of the 90 MW BMGS by UNS Electric from UED and include the cost of the project in rate base effective June 1, 2008. The ACC denied UNS Electric’s requested rate base treatment of BMGS. As a result, UED and UNS Electric have entered into a 5-year Power Purchase Agreement (PPA) under which UED sells all the output of BMGS to UNS Electric. The PPA is a tolling arrangement in which UNS Electric takes operational control of BMGS and assumes all risk of operation and maintenance costs, including fuel. UNS Electric accounts for the PPA as an operating lease. The costs associated with the PPA are recoverable through UNS Electric’s PPFAC.

Renewable Energy Standard Tariff (REST)

The ACC approved a REST surcharge for UNS Electric, effective June 1, 2008, to allow UNS Electric to recover the cost of qualified renewable expenditures, such as payments to customers who have renewable energy resources or the incremental cost of renewable power generated or purchased by UNS Electric. Any surcharge collected in excess of qualified renewable expenditures will be reflected in the financial statements as a current regulatory liability. Conversely, qualified renewable expenditures in excess of the REST surcharge will be reflected as a current regulatory asset. At September 30, 2008, UNS Electric had a current regulatory liability of less than $1 million.

The REST plan includes an adjustor mechanism which allows UNS Electric to file an application with the ACC to apply any shortage or surplus in the prior year’s program expenses to the subsequent year’s REST surcharge.

Future Implications of Discontinuing Application of FAS 71

UNS Electric regularly assesses whether it can continue to apply FAS 71 to its regulated operations. If UNS Electric stopped applying FAS 71, it would write-off the related balances of its regulatory assets as an expense and would write-off its regulatory liabilities as income on its income statement. Based on the regulatory asset and liability balances, if UNS Electric had stopped applying FAS 71, it would have recorded an extraordinary after-tax gain of $1 million at September 30, 2008. While regulatory orders and market conditions may affect cash flows, UNS Electric’s cash flows would not be affected if it stopped applying FAS 71.

NOTE 3. DEBT AND CREDIT FACILITIES

UniSource Energy Credit Agreement

At September 30, 2008 and December 31, 2007, UniSource Energy had $42 million and $20 million, respectively, in borrowings outstanding under its revolving credit facility. We have included these borrowings in Long-Term Debt as UniSource Energy has the ability and the intent to keep the borrowings outstanding for the next twelve months.

The UniSource Credit Agreement restricts additional indebtedness, liens, mergers, sales of assets, and certain investments and acquisitions. We must also meet: (1) a minimum cash flow to debt service coverage ratio for UniSource Energy on a standalone basis and (2) a maximum leverage ratio on a consolidated basis. As a result of higher than expected fuel and purchased power costs, in September 2008, UniSource Energy amended the UniSource Credit Agreement to provide more flexibility to meet the leverage ratio test for the next four calendar quarters, ending June 30, 2009. The leverage ratio is calculated as the ratio of consolidated total indebtedness to consolidated earnings before interest, taxes, depreciation and amortization (EBITDA). As of September 30, 2008, UniSource Energy was in compliance with the terms of its credit agreement.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

TEP Credit Agreement

The TEP Credit Agreement restricts additional indebtedness, liens, mergers, sales of assets, and sale-leaseback transactions. The TEP Credit Agreement also requires TEP to meet a minimum cash coverage ratio and a maximum leverage ratio. As a result of higher than expected fuel and purchased power costs, TEP amended the TEP Credit Agreement in September 2008, to provide more flexibility to meet the leverage ratio test for the next four calendar quarters, ending June 30, 2009. The leverage ratio is calculated as the ratio of consolidated total indebtedness to consolidated earnings before interest, taxes, depreciation and amortization (EBITDA). As of September 30, 2008, TEP was in compliance with all the terms of its credit agreement.

TEP Letter of Credit Facility

On April 30, 2008, TEP entered into a three-year $132 million letter of credit and reimbursement agreement (2008 TEP Letter of Credit Facility). The 2008 TEP Letter of Credit Facility supports $130 million aggregate principal amount of variable rate tax-exempt IDBs that were issued on behalf of TEP in June 2008. (See Pima B Bonds below).

Interest rates and fees under the 2008 TEP Letter of Credit Facility are based on a pricing grid tied to TEP’s credit ratings. Based on TEP’s current credit ratings, the letter of credit fees are 0.75% per annum during the first two years and 0.875% in the third year.

The TEP Letter of Credit Facility contains substantially the same restrictive covenants as the TEP Credit Agreement described above. As of September 30, 2008, TEP was in compliance with all the terms of its credit agreement.

TEP Long-Term Debt

Pima A Bonds

In March 2008, The Industrial Development Authority of Pima County (Pima Authority) issued, for the benefit of TEP, approximately $91 million of its 2008 Series A tax-exempt, unsecured, 6.375% bonds (Pima A Bonds) due September 1, 2029. The proceeds were used to redeem a corresponding principal amount of bonds previously issued by the Pima Authority for TEP’s benefit, which TEP repurchased in 2005. In 2005, TEP did not cancel the repurchased bonds, which remained outstanding under their respective indentures but were not reflected as debt on the balance sheet. As holder of the repurchased bonds, TEP received the payment of the redemption price.

TEP used the redemption proceeds to repay $75 million in revolving loans outstanding under its revolving credit facility. The remaining proceeds were used in May 2008 to redeem $10 million of the $138 million 7.5% Collateral Trust Bonds due August 2008. TEP capitalized $1 million of costs related to the issuance of the 2008 Pima A Bonds and will amortize these costs through August 2029, the term of the bonds.

Interest on the 2008 Pima A Bonds is payable semi-annually, commencing on September 1, 2008.

Beginning on March 1, 2013, TEP will have the option to redeem the 2008 Pima A Bonds, in whole or in part, for cash, at a price equal to 100% of the principal amount, plus accrued interest.

Pima B Bonds

In June 2008, the Pima Authority issued for TEP’s benefit, $130 million of its 2008 Series B tax-exempt IDBs (Pima B Bonds) due September 1, 2029. The 2008 Pima B Bonds are supported by a letter of credit (LOC) issued under the TEP 2008 Letter of Credit Facility. The LOC is secured by $132 million of 1992 Mortgage Bonds and expires April 30, 2011. The proceeds were used to redeem a corresponding principal amount of bonds previously issued by the Pima Authority for TEP’s benefit which TEP repurchased in 2005. TEP did not cancel the repurchased bonds, which remained outstanding under their respective indentures but were not reflected as debt on the balance sheet. As holder of the repurchased bonds being redeemed, TEP received the payment of the redemption price.

TEP deposited the redemption proceeds for its 7.5% collateral trust bonds with a trustee. On August 1, 2008, the deposit was applied to the payment of $128 million of principal plus $5 million of accrued interest on such bonds at maturity.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

TEP was required to deposit these funds with the trustee pursuant to amendments dated May 30, 2008 to the TEP Credit Agreement and the 2008 TEP Letter of Credit Facility. These amendments allowed TEP to exclude the $128 million of collateral trust bonds to be retired on August 1, 2008 from Total Indebtedness for the calculation of its leverage ratio covenant at June 30, 2008.

TEP capitalized $1 million of costs related to the issuance of the 2008 Pima B Bonds and will amortize these costs through August 2029.

The 2008 Pima B Bonds accrue interest at a rate which resets weekly unless and until the interest rate mode is converted to another permitted interest rate mode, such as a term rate. The average weekly interest rate on TEP’s Pima B Bonds ranged from 1.25% to 1.65% until mid-September 2008, when the short-term debt markets began to experience significant disruptions following the bankruptcy filing of Lehman Brothers Holdings, Inc. and the deterioration of creditworthiness of other large financial institutions. In mid-September 2008, the average weekly interest rate reached as high as 8.25%. As of November 4, the average rate on this debt was 1.75%. TEP pays a remarketing fee of 10 basis points (bps) to the remarketing agent of the bonds, an LOC fee of 75 bps to the lenders, and an LOC issuing fee of 12.5 bps to the issuing bank.

UNS Electric Long-Term Debt

On August 7, 2008, UNS Electric issued $100 million of senior unsecured debt; $50 million at 6.5%, due 2015 and $50 million at 7.1%, due 2023 (UNS Electric 2008 Long-Term Debt). The UNS Electric 2008 Long-Term Debt is guaranteed by UES.

UNS Electric used $60 million of the proceeds to repay the 7.61% senior unsecured notes that matured on August 11, 2008. The remaining proceeds were used to repay UNS Electric’s outstanding borrowings under the UNS Gas/UNS Electric Revolver and for general corporate purposes.

UNS Electric capitalized $1 million of costs related to the issuance of the debt and will amortize these costs over the life of the debt.

The UNS Electric 2008 Long-Term Debt contains certain restrictive covenants, including restrictions on transactions with affiliates, mergers, liens to secure indebtedness, restricted payments and incurrence of indebtedness. As of September 30, 2008, UNS Electric was in compliance with the terms of its note purchase agreement.

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

TEP Revolving Credit Facility

At September 30, 2008 and December 31, 2007, TEP had $10 million in borrowings outstanding and no letters of credit issued under its revolving credit facility.

UNS Gas/UNS Electric Revolving Credit Agreement

The borrowings under the UNS Gas/UNS Electric Revolver were as follows:


	UNS		UNS		UNS		UNS
	Gas		Electric		Gas		Electric
	-Millions of Dollars-
	September 30, 2008				December 31, 2007
Balance on the Revolver	$	—	$	8	$	—	$	26

Outstanding Letters of Credit	$	—	$	12	$	10	$	—

At September 30, 2008 and December 31, 2007, UNS Electric’s borrowings under the UNS Gas/UNS Electric Revolver were excluded from Current Liabilities and presented as Long-Term Debt, as UNS Electric has the ability and the intent to keep the borrowings outstanding under the UNS Gas/UNS Electric Revolver for the next twelve months.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

NOTE 4. BUSINESS SEGMENTS

Based on the way we organize our operations and evaluate performance, we have three reportable segments:

	(1)		TEP, a vertically integrated electric utility business, is UniSource Energy’s largest subsidiary.

	(2)		UNS Gas is a regulated gas distribution utility business.

	(3)		UNS Electric is a regulated electric distribution utility business.

The UniSource Energy, UES and Millennium holding companies, UED, and several other subsidiaries and equity investments, which are not considered reportable segments, are included in Other. Through affiliates, Millennium holds investments in several unregulated companies. UED owns the BMGS and through a PPA, provides energy to UNS Electric.

We disclose selected financial data for our reportable segments in the following table:


	Reportable Segments														UniSource
				UNS			UNS					Reconciling			Energy
	TEP			Gas			Electric		Other			Adjustments			Consolidated
	-Millions of Dollars-
Statements of Income (Loss)
Three months ended September 30, 2008:
Operating Revenues — External	$	305		$	20		$	63	$	—		$	—		$	388
Operating Revenues — Intersegment		19			3			5		7			(34	)		—
Income (Loss) Before Income Taxes		(17	)		(2	)		4		—			—			(15	)
Net Income (Loss)	$	(12	)	$	(1	)	$	3	$	(1	)	$	—		$	(11	)

Three months ended September 30, 2007:
Operating Revenues — External	$	327		$	17		$	54	$	—		$	—		$	398
Operating Revenues — Intersegment		2			—			—		3			(5	)		—
Income (Loss) Before Income Taxes		42			(4	)		5		(2	)		—			41
Net Income (Loss)	$	26		$	(2	)	$	3	$	(2	)	$	—		$	25

Nine months ended September 30, 2008:
Operating Revenues — External	$	817		$	117		$	144	$	—		$	—		$	1,078
Operating Revenues — Intersegment		29			6			7		16			(58	)		—
Income (Loss) Before Income Taxes		(20	)		9			6		(5	)		—			(10	)
Net Income (Loss)	$	(15	)	$	5		$	4	$	(3	)	$	—		$	(9	)

Nine months ended September 30, 2007:
Operating Revenues — External	$	812		$	103		$	131	$	—		$	—		$	1,046
Operating Revenues — Intersegment		5			—			—		12			(17	)		—
Income (Loss) Before Income Taxes		64			2			8		(4	)		—			70
Net Income (Loss)	$	39		$	1		$	5	$	(3	)	$	—		$	42

Balance Sheet
Total Assets, September 30, 2008	$	2,662		$	259		$	271	$	1,045		$	(945	)	$	3,292
Total Assets, December 31, 2007		2,573			276			226		1,077			(966	)		3,186


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

Reconciling adjustments consist of the elimination of intersegment revenue which were due to the following transactions:


	Reportable Segments								UniSource			UniSource
			UNS		UNS				Energy			Energy
	TEP		Gas		Electric		Other		Eliminations			Consolidated
	-Millions of Dollars-
Intersegment Revenue
Three months ended September 30, 2008:
Wholesale Sales — TEP to UNSE	$	16	$	—	$	—	$	—	$	(16	)	$	—
Wholesale Sales — UNSE to TEP		—		—		5		—		(5	)		—
Wholesale Sales — UED to UNSE		—		—		—		3		(3	)		—
Gas Revenue — UNSG to UNSE		—		3		—		—		(3	)		—
Other Revenue — TEP to Affiliates⁽¹⁾		2		—		—		—		(2	)		—
Other Revenue — MEH to TEP & UNSE⁽²⁾		—		—		—		4		(4	)		—
Other Revenue — TEP to UNSE⁽³⁾		1		—		—		—		(1	)		—

Total Intersegment Revenue	$	19	$	3	$	5	$	7	$	(34	)	$	—


Three months ended September 30, 2007:
Other Revenue — TEP to Affiliates⁽¹⁾	$	2	$	—	$	—	$	—	$	(2	)	$	—
Other Revenue — MEH to TEP & UNSE⁽²⁾		—		—		—		3		(3	)		—

Total Intersegment Revenue	$	2	$	—	$	—	$	3	$	(5	)	$	—


Nine months ended September 30, 2008:
Wholesale Sales — TEP to UNSE	$	22	$	—	$	—	$	—	$	(22	)	$	—
Wholesale Sales — UNSE to TEP		—		—		7		—		(7	)		—
Wholesale Sales — UED to UNSE		—		—		—		4		(4	)		—
Gas Revenue — UNSG to UNSE		—		6		—		—		(6	)		—
Other Revenue — TEP to Affiliates⁽¹⁾		6		—		—		—		(6	)		—
Other Revenue — MEH to TEP & UNSE⁽²⁾		—		—		—		12		(12	)		—
Other Revenue — TEP to UNSE⁽³⁾		1		—		—		—		(1	)		—

Total Intersegment Revenue	$	29	$	6	$	7	$	16	$	(58	)	$	—


Nine months ended September 30, 2007:
Other Revenue — TEP to Affiliates⁽¹⁾	$	5	$	—	$	—	$	—	$	(5	)	$	—
Other Revenue — MEH to TEP & UNSE⁽²⁾		—		—		—		12		(12	)		—

Total Intersegment Revenue	$	5	$	—	$	—	$	12	$	(17	)	$	—


(1)		TEP provides all corporate services (finance, accounting, tax, information technology services, etc) to UniSource Energy and its subsidiaries.

(2)		SES, a Millennium subsidiary, provides a supplemental workforce to TEP and UNS Electric.

(3)		TEP provides control area services to UNS Electric.

Other significant reconciling adjustments include intercompany interest between UniSource Energy and UED, the elimination of investments in subsidiaries held by UniSource Energy and reclassifications of deferred tax assets and liabilities.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

NOTE 5. ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND TRADING ACTIVITIES

TEP INTEREST RATE SWAP

In June 2006, TEP entered into an interest rate swap to reduce the risk of unfavorable changes in variable interest rates related to changes in LIBOR. The swap has the effect of converting approximately $36 million of variable rate lease payments for the Springerville Common Lease to a fixed rate through January 1, 2020. The swap is designated as a cash flow hedge for accounting purposes. Because the changes in interest payments, resulting from changes in LIBOR, were completely offset by the interest rate swap in the three and nine months ended September 30, 2008, there was no ineffectiveness recorded in earnings.

FUEL AND POWER TRANSACTIONS

TEP, UNS Gas and UNS Electric enter into forward contracts to purchase or sell a specified amount of capacity or energy at a specified price over a given period of time, within established limits to take advantage of favorable market opportunities and reduce exposure to energy price risk. TEP, UNS Gas and UNS Electric also have natural gas supply agreements under which each company purchases all of its gas requirements at spot market prices. In an effort to minimize price risk on these purchases and sales, TEP, UNS Gas and UNS Electric enter into gas price swap agreements under which they purchase gas at fixed prices and simultaneously sell gas at spot market prices. All of the contracts and agreements referred to in this paragraph are considered derivative instruments.

On the date the company enters into a contract that is considered a derivative instrument, we apply one of the following accounting treatments:

	•		Cash Flow Hedges are used by TEP and UNS Gas to hedge the changes in cash flows that are to be received or paid in connection with gas swap agreements and forward power sales. These contracts hedge the cash flow risk associated with TEP’s summer load requirements and its forecasted excess generation and UNS Gas’ winter load requirement. The effective portion of the changes in the market prices of cash flow hedges are recorded as unrealized gains and losses in Accumulated Other Comprehensive Income (AOCI) and the ineffective portion, if any, is recognized in earnings.

			TEP and UNS Gas discontinue cash flow hedge accounting prospectively, when they determine that a contract is no longer effective in offsetting the changes in cash flows of a hedged item. When TEP or UNS Gas discontinue cash flow hedge accounting, the gains and losses at that time remain in AOCI and are reclassified into earnings as the underlying hedged transaction occurs. TEP and UNS Gas continue to carry the contract at fair value and recognize changes in fair value in current period earnings.

	•		Mark-to-Market transactions include:

	•		TEP non-trading hedges, such as forward power purchase contracts indexed to gas that did not qualify for cash flow hedge accounting treatment or did not qualify for the normal scope exception. Unrealized gains and losses resulting from changes in the market prices of non-trading hedges are recorded on the same line in the income statement as the hedged transaction.

	•		TEP trading derivatives which are forward power purchase and sale contracts entered into to reduce our exposure to energy and commodity prices. Unrealized gains and losses resulting from changes in the market prices of trading derivatives are recorded in the income statement in Electric Wholesale Sales.

	•		UNS Electric derivatives such as forward power purchases and gas swaps. In December 2006, UNS Electric received authorization from the ACC to defer the unrealized gains and losses on the balance sheet as a regulatory asset or a regulatory liability rather than as a component of AOCI or in the income statement.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

These mark-to-market contracts are subject to specified risk parameters established and monitored by UniSource Energy’s Risk Management Committee.

•

Normal Purchase and Sale transactions are forward energy purchase and sales contracts entered into by TEP, UNS Gas and UNS Electric to support the current load forecast and entered into with a counterparty with load serving requirements or generating capacity. These contracts are not required to be marked-to-market and are accounted for on an accrual basis.

TEP has energy contracts and an interest rate swap that are accounted for as cash flow hedges. UNS Gas also has energy contracts accounted for as cash flow hedges. The net unrealized gains and losses on these contracts reported in Other Comprehensive Income were as follows:


	UniSource Energy
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
Cash Flow Hedges - Unrealized Gains (Losses)
Recorded to AOCI	2008			2007			2008			2007
	-Millions of Dollars-

Forward Power Sales	$	5		$	1		$	2		$	—
Gas Price Swaps		(44	)		(3	)		(10	)		(6	)
Interest Rate Swap		(1	)		(1	)		—			1

Total Pre-Tax Unrealized Gain (Loss)	$	(40	)	$	(3	)	$	(8	)	$	(5	)


After-Tax Unrealized Gain (Loss) Recorded in AOCI	$	(24	)	$	(2	)	$	(5	)	$	(3	)


Unrealized (Gain) Loss Reclassified to Net Income	$	1		$	4		$	(1	)	$	2


	TEP
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
Cash Flow Hedges - Unrealized Gains (Losses)
Recorded to AOCI	2008			2007			2008			2007
	-Millions of Dollars-

Forward Power Sales	$	5		$	1		$	2		$	—
Gas Price Swaps		(27	)		(4	)		—			(6	)
Interest Rate Swap		(1	)		(1	)		—			1

Total Pre-Tax Unrealized Gain (Loss)	$	(23	)	$	(4	)	$	2		$	(5	)


After-Tax Unrealized Gain (Loss) Recorded in AOCI	$	(14	)	$	(2	)	$	1		$	(3	)


Unrealized (Gain) Loss Reclassified to Net Income	$	1		$	4		$	(1	)	$	2

TEP has a gas swap agreement, designated as a cash flow hedge, with a counterparty, whose parent and guarantor declared bankruptcy in August 2008. At September 30, 2008, TEP reclassified a net loss of less than $0.1 million to earnings, because it was unable to conclude that this cash flow hedge was highly effective in generating offsetting cash flows. A balance of less than $0.1 million will remain in AOCI and will be reclassified to earnings as the forecasted purchases of gas occur.

TEP and UNS Gas concluded, following an assessment at the inception of a hedge transaction and on an ongoing basis, that its remaining derivatives, designated as cash flow hedges, have been highly effective in offsetting changes in the cash flows of hedged items and that those derivatives, are expected to remain highly effective in future periods.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

The unrealized gains and losses on TEP’s energy contracts that are marked to market through earnings were as follows:


	UniSource Energy and TEP
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
	-Millions of Dollars-
Recorded in Wholesale Sales:
Forward Power Sales	$	28		$	1		$	13		$	7
Forward Power Purchases		(28	)		—			(14	)		(7	)
Forward Power Purchases Recorded in Purchased Energy		1			(1	)		(1	)		—
Forward Gas Price Swaps Recorded in Fuel		(7	)		—			(3	)		—

Total Pre-Tax Unrealized Gain (Loss)	$	(6	)	$	—		$	(5	)	$	—

The following table discloses UNS Electric’s unrealized gains and losses on energy contracts, which are reported on the UniSource Energy balance sheet as a regulatory asset or a regulatory liability rather than as a component of OCI or in the income statement.


	UniSource Energy
	Three Months Ended						Six Months Ended
Mark-to-Market Transactions - Increase (Decrease)	September 30,						September 30,
Recorded in Regulatory Accounts on the Balance Sheet	2008			2007			2008			2007
	-Millions of Dollars-
Recorded in Current Regulatory Assets — Derivatives:
Gas Swaps	$	(2	)	$	—		$	(2	)	$	—
Power Purchases		(5	)		—			(5	)		—
Recorded in Current Regulatory Liabilities — Derivatives:
Gas Swaps		(6	)		—			—			—
Power Purchases		(25	)		3			(3	)		3
Recorded in Other Regulatory Assets — Derivatives:
Gas Swaps		(1	)		—			(1	)		(1	)
Power Purchases		(5	)		—			(5	)		—
Recorded in Other Regulatory Liabilities — Derivatives:
Gas Swaps		(4	)		—			—			—
Power Purchases		(10	)		(8	)		(6	)		(2	)

Total Increase (Decrease)	$	(58	)	$	(5	)	$	(22	)	$	—


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

The fair value of derivative assets and liabilities were as follows:


	UniSource Energy
	September 30, 2008									December 31, 2007
				Cash									Cash
	Mark-to-Market			Flow						Mark-to-Market			Flow
	Contracts			Hedges			Total			Contracts			Hedges			Total
	-Millions of Dollars-
Derivative Assets — Current	$	10		$	4		$	14		$	4		$	1		$	5
Derivative Liabilities — Current		(22	)		(9	)		(31	)		(1	)		(2	)		(3	)

Net Current Derivative Assets (Liabilities)	$	(12	)	$	(5	)	$	(17	)	$	3		$	(1	)	$	2


Derivative Assets — Noncurrent	$	6		$	—		$	6		$	8		$	—		$	8
Derivative Liabilities — Noncurrent		(12	)		(8	)		(20	)		(2	)		(3	)		(5	)

Net Noncurrent Derivative Assets (Liabilities)	$	(6	)	$	(8	)	$	(14	)	$	6		$	(3	)	$	3


	TEP
	September 30, 2008									December 31, 2007
				Cash									Cash
	Mark-to-Market			Flow						Mark-to-Market			Flow
	Contracts			Hedges			Total			Contracts			Hedges			Total
	-Millions of Dollars-
Derivative Assets — Current	$	10		$	4		$	14		$	1		$	1		$	2
Derivative Liabilities — Current		(14	)		(3	)		(17	)		(1	)		(2	)		(3	)

Net Current Derivative Assets (Liabilities)	$	(4	)	$	1		$	(3	)	$	—		$	(1	)	$	(1	)


Derivative Assets — Noncurrent	$	4		$	—		$	4		$	—		$	—		$	—
Derivative Liabilities — Noncurrent		(4	)		(5	)		(9	)		—			(3	)		(3	)

Net Noncurrent Derivative Assets (Liabilities)	$	—		$	(5	)	$	(5	)	$	—		$	(3	)	$	(3	)

At September 30, 2008, TEP, UNS Electric and UNS Gas had contracts that will settle through the third quarter of 2011, the fourth quarter of 2013, and the third quarter of 2011, respectively. Amounts presented as Cash Flow Hedges, Derivative Assets — Current and Derivative Liabilities - Current, are expected to be reclassified into earnings within the next twelve months.

Credit Risk

When the fair value of a TEP or UniSource Energy derivative contract is positive, the counterparty owes UniSource Energy or TEP and this creates a credit risk. UniSource Energy and TEP minimize their credit risk by (1) entering into transactions with high-quality counterparties, (2) limiting their exposure to each counterparty, (3) monitoring the financial condition of its counterparties and (4) requiring collateral when needed. Using a combination of market credit default swap data and historical recovery rates for subordinated bonds, UniSource Energy and TEP consider the impact of counterparty credit worthiness in determining the fair value of their derivatives as well as its possible effect on continued qualification for cash flow hedge accounting. At September 30, 2008, the impact of counterparty credit risk on the fair value of positive derivative contracts was less than $0.5 million.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

The settlement of forward power purchase and sales contracts entered into to reduce TEP’s exposure to changes in energy and commodity prices were as follows:


	UniSource Energy and TEP
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
	-Millions of Dollars-
Recorded in Wholesale Sales:
Forward Power Sales	$	19		$	7		$	50		$	49
Forward Power Purchases		(18	)		(8	)		(50	)		(50	)

Total Pre-Tax Realized Gain (Loss)	$	1		$	(1	)	$	—		$	(1	)

The settlement of forward power purchase and sales contracts that do not result in physical delivery were as follows:


	UniSource Energy and TEP
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
	-Millions of Dollars-
Recorded in Wholesale Sales:
Forward Power Sales	$	13		$	8		$	25		$	14
Forward Power Purchases		(13	)		(8	)		(25	)		(14	)

Total Sales and Purchases Not Resulting in Physical Delivery	$	—		$	—		$	—		$	—


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

NOTE 6. INCOME TAX MATTERS

INCOME TAXES

The differences between the income tax expense (benefit) reflected on the income statements and the amount obtained by multiplying pre-tax income by the U.S. statutory federal income tax rate of 35% were as follows:


	UniSource Energy
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
	-Millions of Dollars-

Federal Income Tax Expense (Benefit) at Statutory Rate	$	(5	)	$	14		$	(3	)	$	24
State Income Tax Expense (Benefit), Net of Federal Deduction		(1	)		2			(1	)		3
San Juan Environmental Penalties		2			—			2			—
State Tax Credits		(1	)		—			(2	)		—
Depreciation Differences (Flow Through Basis)		1			1			2			2
Other		—			(1	)		1			(1	)

Total Federal and State Income Tax Expense (Benefit)	$	(4	)	$	16		$	(1	)	$	28


	TEP
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
	-Millions of Dollars-

Federal Income Tax Expense (Benefit) at Statutory Rate	$	(6	)	$	14		$	(7	)	$	22
State Income Tax Expense (Benefit), Net of Federal Deduction		(1	)		2			(1	)		3
San Juan Environmental Penalties		2			—			2			—
State Tax Credits		(1	)		—			(2	)		—
Depreciation Differences (Flow Through Basis)		1			1			2			2
Other		—			(1	)		1			(2	)

Total Federal and State Income Tax Expense (Benefit)	$	(5	)	$	16		$	(5	)	$	25


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

UNCERTAIN TAX POSITIONS

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

In 2005, the Internal Revenue Service issued a ruling limiting the ability of electric and gas utilities to use the new accounting method. As a result, TEP, UNS Gas and UNS Electric amended their 2002, 2003 and 2004 federal and state tax returns to remove the benefit previously claimed using the accounting method and remitted tax and interest of $31 million, $1 million and $0.3 million, respectively, to the IRS and state tax authorities. Based on settlement guidelines relating to the accounting method issued by the IRS in March 2007, TEP, UNS Gas and UNS Electric have settled this issue with the IRS. In December 2007, TEP recorded the effect of the settlement by recognizing $2 million of interest income. In 2008, UniSource Energy received a $16 million refund of taxes and interest, of which $15 million relates to TEP. The refunds have no income statement impact to UniSource Energy or TEP.

On September 15, 2008, the statute of limitations expired for the 2004 tax year. As a result of the closure of the statute, TEP reversed $1 million of previously recorded interest expense associated with uncertain tax positions. In the third quarter, TEP recorded a $5 million increase in deferred tax liabilities associated with uncertain tax positions taken in the current period, of which $1 million increased deferred tax expense recorded at UniSource Energy and TEP. No material decreases in unrecognized tax benefits are expected within the next twelve months, and we are unable to determine whether any increase will occur.

NOTE 7. COMMITMENTS AND CONTINGENCIES

TEP COMMITMENTS

In 2008, TEP entered into additional forward power supply agreements through 2009. Certain of these contracts are at a fixed price per MW and others are indexed to natural gas prices. TEP estimates its minimum payments under these contracts to be $9 million in the fourth quarter of 2008 and $41 million in 2009 based on natural gas prices at September 30, 2008. In addition, TEP entered into a forward call option agreement for the period 2009 through 2014. TEP estimates its minimum capacity payments under this contract to be $2 million in 2009 and $3 million in each of the years 2010 through 2014.

In 2008, TEP entered into additional forward gas purchase agreements through August 2011. TEP estimates its minimum payments for these forward purchases to be $2 million in the fourth quarter of 2008, $25 million in 2009, $9 million in 2010, and $2 million in 2011.

In 2008, TEP entered into agreements to purchase coal for Sundt Generating Station for 2009. TEP estimates the minimum payments under these contracts to be approximately $21 million in 2009.

In March 2008, TEP entered into a five-year gas transportation agreement with El Paso Natural Gas. TEP estimates its minimum payments under this contract to be $2 million in 2008, $3 million in 2009, $4 million in each of 2010 through 2012, and less than $1 million in 2013.

UNS ELECTRIC COMMITMENTS

In 2008, UNS Electric entered into forward gas purchase agreements through August 2011. UNS Electric estimates its minimum payments for these forward purchases to be less than $1 million in the fourth quarter of 2008, $6 million in 2009, $3 million in 2010, and less than $1 million in 2011.

In 2008, UNS Electric entered into forward power purchase agreements through 2010. Certain of these contracts are at a fixed price per MW and others are indexed to natural gas prices. UNS Electric estimates its minimum payments under these contracts to be $22 million in 2009 and $11 million in 2010 based on natural gas prices at September 30, 2008.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

UNS GAS COMMITMENTS

In 2008, UNS Gas entered into forward gas purchase agreements through August 2011. UNS Gas estimates its minimum payments for these forward purchases to be $10 million in the fourth quarter of 2008, $18 million in 2009, $12 million in 2010, and $7 million in 2011.

TEP CONTINGENCIES

Claims Related to Springerville Unit 3

TEP operates Springerville Unit 3 on behalf of Tri-State under a 99-year operating agreement. TEP may potentially have to reimburse Tri-State $1 million pending resolution of a dispute over administrative and general costs. TEP has not recorded a liability for these claims.

Regional Haze

The EPA’s regional haze rules require emission controls known as Best Available Retrofit Technology (BART) for certain industrial facilities emitting air pollutants that reduce visibility. The operators of the Four Corners, Navajo, and San Juan generating stations submitted BART analyses in 2007 and early 2008. PNM, operator of San Juan, believes the controls being installed at San Juan as a result of the 2005 settlement agreement between PNM, environmental activist groups, and the New Mexico Environment Department (PNM Consent Decree) constitute BART and did not recommend installation of any additional pollution control equipment. The operators of the Four Corners and Navajo generating stations recommended installing certain additional pollution control equipment in their respective BART analyses. The level and cost of pollution control required, if any, will not be known until the plans are approved by the regulatory agencies. If required, controls would need to be in place by 2013 or later.

Claims Related to San Juan Coal Company

San Juan Coal Company, the coal supplier to San Juan, through leases with the federal government and the State of New Mexico, owns coal interests with respect to an underground mine. Certain gas producers have oil and gas leases with the federal government, the State of New Mexico and private parties in the area of the underground mine. These gas producers allege that San Juan Coal Company’s underground coal mining operations have or will interfere with their gas production and will reduce the amount of natural gas that they would otherwise be entitled to recover. San Juan Coal Company has compensated certain gas producers for any remaining gas production from a well when it was determined that mining activity was close enough to warrant shutting down the well. These settlements, however, do not resolve all potential claims by gas producers in the underground mine area. TEP cannot estimate the impact of any future claims by these gas producers on the cost of coal at San Juan.

Environmental Reclamation at Remote Generating Stations

TEP currently pays on-going reclamation costs related to the coal mines which supply the remote generating stations, and it is probable that TEP will have to pay a portion of final reclamation costs upon mine closure. When a reasonable estimate of final reclamation costs is available, the liability is recognized as a cost of coal over the remaining term of the corresponding coal supply agreement. At September 30, 2008, TEP has recorded a liability of $8 million based on our $17 million obligation at the expiration dates of the coal supply agreements in 2011 through 2017. At December 31, 2007, TEP had recorded a liability of $4 million. See Resolution of TEP Contingencies - Navajo Generating Station below.

Amounts recorded for final reclamation are subject to various assumptions, such as estimating the costs of reclamation, when final reclamation will occur, and the credit-adjusted risk-free interest rate to be used to discount future liabilities. As these assumptions change, TEP will prospectively adjust the expense amounts for final reclamation over the remaining coal supply agreement term. TEP does not believe that recognition of its final reclamation obligations will be material to TEP in any single year because recognition occurs over the remaining terms of its coal supply agreements.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

TEP Wholesale Accounts Receivable and Allowances

TEP’s Accounts Receivable from Electric Wholesale Sales includes $16 million of receivables at September 30, 2008 and December 31, 2007 related to sales to the California Power Exchange (CPX) and the California Independent System Operator (CISO) in 2001 and 2000. TEP’s Allowance for Doubtful Accounts on the balance sheet includes $13 million at September 30, 2008 and December 31, 2007 related to these sales. There are several outstanding legal issues, complaints and lawsuits concerning the California energy crisis related to the FERC, wholesale power suppliers, Southern California Edison Company, Pacific Gas and Electric Company, the CPX and the CISO. We cannot predict the outcome of these issues or lawsuits. We believe, however, that TEP is adequately reserved for its transactions with the CPX and the CISO.

Tucson to Nogales Transmission Line

TEP and UNS Electric are parties to a project development agreement for the joint construction of an approximately 60-mile transmission line from Tucson to Nogales, Arizona. UNS Electric’s participation in this project was initiated in response to an order by the ACC to improve reliability to UNS Electric’s retail customers in Nogales, Arizona.

In 2002, the ACC approved the location and construction of the proposed 345-kV line along a route identified as the Western Corridor route subject to a number of conditions, including obtaining all required permits from state and federal agencies. The U.S. Forest Service subsequently identified a preference for a route identified as the Central Corridor route in the final Environmental Impact Statement for the project. TEP is considering options for the project including potential new routes. If a decision is made to pursue an alternative route, approvals will be needed from the ACC, the Department of Energy, U.S. Forest Service, Bureau of Land Management, and the International Boundary and Water Commission. If TEP does not receive the required approvals, it may need to expense a portion of the $9 million of costs that have been capitalized related to the project.

RESOLUTION OF TEP CONTINGENCIES — Navajo Generating Station

In 2004, Peabody Western Coal Company (Peabody), the coal supplier to the Navajo Generating Station, filed a complaint in the Circuit Court for the City of St. Louis, Missouri against the participants at Navajo, including TEP (7.5% owner), for reimbursement of royalties and other costs and breach of the coal supply agreement. In July 2008, the parties entered into a joint stipulation of dismissal of these claims which was approved by the court. TEP had not recorded a liability for these claims.

In addition, in 1996, SRP filed a lawsuit in Maricopa County Superior Court on behalf of the participants at Navajo Generating Station, including TEP, seeking declaratory judgment that the Navajo Generating Station participants are not responsible for postretirement benefit costs payable to the coal supplier’s employees and final reclamation costs after the coal supply agreement expires and the mine closes. The Navajo Generating Station participants and Peabody entered into a settlement agreement, which was approved by the court in the third quarter of 2008, and thereafter dismissed the lawsuit with prejudice. As a result of this settlement agreement, TEP recorded the present value of its share of the postretirement benefit costs, totaling $6 million, and final reclamation costs, totaling $3 million, as fuel expense in the third quarter. TEP will recognize additional expense and increase its liabilities over the remaining life of the coal supply agreement, and will pay its share of the settlement as coal is purchased in the future with an estimated annual cash impact of approximately $1 million per year from 2008 to 2026.

GUARANTEES AND INDEMNITIES

In the normal course of business, UniSource Energy and certain subsidiaries enter into various agreements providing financial or performance assurance to third parties on behalf of certain subsidiaries. We enter into these agreements primarily to support or enhance the creditworthiness of a subsidiary on a stand-alone basis. The most significant of these guarantees are:

	•		UES’ guarantee of senior unsecured notes issued by UNS Gas ($100 million) and by UNS Electric ($100 million),

	•		UES’ guarantee of the $60 million UNS Gas/UNS Electric Revolver, and

	•		UniSource Energy’s guarantee of approximately $2 million in building lease payments for UNS Gas.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

To the extent liabilities exist under these contracts, the liabilities are included in our consolidated balance sheets.

In addition, we have indemnified the purchasers of interests in certain investments from additional taxes due for years before the sale of such investments. The terms of the indemnifications do not include a limit on potential future payments; however, we believe that we have abided by all tax laws and paid all tax obligations. We have not made any payments under the terms of these indemnifications to date.

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

NOTE 8. EMPLOYEE BENEFIT PLANS

PENSION BENEFIT PLANS

TEP, UNS Gas and UNS Electric maintain noncontributory, defined benefit pension plans for substantially all regular employees and certain affiliate employees. Benefits are based on years of service and the employee’s average compensation. TEP, UNS Gas and UNS Electric fund the plans by contributing at least the minimum amount required under Internal Revenue Service regulations. Additionally, we provide supplemental retirement benefits to certain employees whose benefits are limited by Internal Revenue Service benefit or compensation limitations.

OTHER POSTRETIREMENT BENEFIT PLANS

TEP provides limited health care and life insurance benefits for retirees. All regular employees may become eligible for these benefits if they reach retirement age while working for TEP or an affiliate. UNS Gas and UNS Electric provide postretirement medical benefits for current retirees and a small group of active employees. The majority of UNS Gas and UNS Electric employees do not participate in the postretirement medical plan.

The ACC allows TEP, UNS Gas and UNS Electric to recover postretirement costs through rates only as benefit payments are made to or on behalf of retirees. The postretirement benefits are currently funded entirely on a pay-as-you-go basis. Under current accounting guidance, TEP, UNS Gas and UNS Electric cannot record a regulatory asset for the excess of expense calculated per FAS 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions, over actual benefit payments.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

COMPONENTS OF NET PERIODIC BENEFIT COSTS

The components of UniSource Energy’s net periodic benefit costs are as follows:


							Other Postretirement
	Pension Benefits						Benefits
	Three Months Ended						Three Months Ended
	September 30,						September 30,
	2008			2007			2008		2007
	-Millions of Dollars-

Components of Net Periodic Benefit Costs
Service Cost	$	2		$	2		$	—	$	—
Interest Cost		4			3			1		1
Expected Return on Plan Assets		(4	)		(4	)		—		—
Prior Service Cost Amortization		1			—			—		—
Recognized Actuarial Loss		—			1			—		—

Net Periodic Benefit Costs	$	3		$	2		$	1	$	1


							Other Postretirement
	Pension Benefits						Benefits
	Nine Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
	-Millions of Dollars-

Components of Net Periodic Benefit Costs
Service Cost	$	6		$	6		$	1		$	1
Interest Cost		11			9			3			3
Expected Return on Plan Assets		(12	)		(11	)		—			—
Prior Service Cost Amortization		1			1			(1	)		(1	)
Recognized Actuarial Loss		—			2			—			—

Net Periodic Benefit Costs	$	6		$	7		$	3		$	3

The tables above include pension benefit costs of $1 million and other postretirement benefit costs of less than $0.1 million for UNS Gas and UNS Electric for all periods presented.

On January 1, 2008, UniSource Energy and TEP adopted the measurement date provisions of FAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FAS Statements No.87, 88, 106, and 132(R).” The measurement date provisions require plan assets and obligations to be measured as of the employer’s balance sheet date. UniSource Energy and TEP previously measured its other postretirement benefit obligations as of December 1 each year. As a result of the adoption of the measurement date provisions, UniSource Energy and TEP recorded an increase of $0.6 million and $0.5 million, respectively, to their postretirement benefit liability, and a corresponding increase to accumulated deficit, representing the net periodic benefit cost for the period between the measurement date utilized in 2007 and the beginning of 2008. The adoption of the measurement provisions of FAS 158 had no effect on UniSource Energy or TEP’s income statements.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

NOTE 9. SHARE-BASED COMPENSATION PLANS

Under the 2006 Omnibus Stock and Incentive Plan, the Compensation Committee of the UniSource Energy Board of Directors may issue various types of share-based compensation, including stock options, restricted shares/units, and performance shares. The total number of shares which may be awarded under the Plan cannot exceed 2.25 million shares. As of September 30, 2008, the total number of shares awarded under the 2006 Omnibus Stock and Incentive Plan was 0.8 million shares.

STOCK OPTIONS

On February 27, 2008, the Compensation Committee of the UniSource Energy Board of Directors granted 303,550 stock options to officers with an exercise price of $26.18. In March 2007, the Compensation Committee granted 184,260 stock options to officers with an exercise price of $37.88.

Stock options are granted with an exercise price equal to the fair market value of the stock on the date of grant, vest over three years, become exercisable in one-third increments on each anniversary date of the grant and expire on the tenth anniversary of the grant. Compensation expense is recorded on a straight-line basis over the service period for the total award based on the grant date fair value of the options less estimated forfeitures. For awards granted to retirement eligible officers, compensation expense is recorded immediately. Certain stock option awards accrue dividend equivalents that are paid in cash on the earlier of the date of exercise of the underlying option or the date the option expires. Compensation expense is recognized as dividends are paid.

The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model with the assumptions noted in the following table. The expected term of the stock options granted in February 2008 was estimated using historical exercise data. The expected term of all other options granted in prior years was estimated using a “simplified” method which considers the 3 year vesting period and the contractual term. The risk-free rate is based on the rate available on a U.S. Treasury Strip with a maturity equal to the expected term of the option at the time of the grant. Expected volatility was based on historical volatility for UniSource Energy’s stock for the past 6 years, the expected term. The expected dividend yield on a share of stock was calculated using the historical dividend yield with the implicit assumption that current dividend yields will continue in the future.


	2008 Grant			2007 Grant
Expected term (years)		6			6
Risk-free rate		3.1	%		4.4	%
Expected volatility		18.8	%		20.2	%
Expected dividend yield		2.8	%		2.4	%
Weighted-average grant-date fair value of options granted	$	4.23		$	8.13


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

A summary of stock option activity follows:


	Nine Months Ended September 30, 2008
	Total Stock Options
	Outstanding					Non-Vested Stock Options
				Weighted					Weighted
				Average					Average
				Exercise					Grant Date
(Shares in Thousands)	Shares			Price		Shares			Value
Options Outstanding, December 31, 2007		1,451		$	21.21		312		$	7.83
Granted		304		$	26.18		304		$	4.23
Exercised or Vested		(116	)	$	16.45		(134	)	$	7.73

Options Outstanding, September 30, 2008		1,639		$	22.47		482		$	5.59

Options Exercisable, September 30, 2008		1,157		$	19.47


Aggregate Intrinsic Value of Options Exercised ($000’s)				$	1,627


	At September 30,
	2008 ($000s)
Aggregate Intrinsic Value for Options Outstanding	$	13,049
Aggregate Intrinsic Value for Options Exercisable	$	12,135
Weighted Average Remaining Contractual Life	4.9 years
Weighted Average Remaining Contractual Life of Exercisable Shares	3.3 years

Exercise prices for stock options outstanding and exercisable as of September 30, 2008 are summarized as follows:


	Options Outstanding					Options Exercisable
			Weighted-
			Average	Weighted-				Weighted-
	Number of		Remaining	Average		Number of		Average
Range of	Shares		Contractual	Exercise		Shares		Exercise
Exercise Prices	(000s)		Life	Price		(000s)		Price
$11.00 - $15.56		417	1.4 years	$	14.12		417	$	14.12
$17.44 - $18.84		524	3.2 years	$	18.02		524	$	18.02
$26.18 - $37.88		698	8.3 years	$	30.80		216	$	33.33

RESTRICTED STOCK UNITS AND PERFORMANCE SHARES

Restricted Stock Units

In 2008, the Compensation Committee of the UniSource Energy Board of Directors granted the following stock units to non-employee directors:

	•		February 2008 — 3,130 stock units at a weighted average fair value of $28.75 per share,

	•		May 2008 — 18,448 stock units at a weighted average fair value of $31.71 per share, and

	•		August 2008 — 1,400 stock units at a weighted average fair value of $32.15 per share.

The restricted stock units vest in one year or immediately upon death, disability, or retirement. In the January following the year the person is no longer a director, Common Stock shares will be issued for the vested stock units. For the nine months ended September 30, 2007, 17,858 stock units at a weighted average fair value of $37.30 per share were issued to non-employee directors.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

Performance Share Awards

On February 27, 2008, the Compensation Committee of the UniSource Energy Board of Directors granted 49,120 performance share awards (targeted shares) to Officers at a grant date fair value of $17.10 per share. The performance share awards will be paid out in shares of UniSource Energy Common Stock based on UniSource Energy’s performance over the performance period of January 1, 2008 through December 31, 2010. The performance criteria specified in the awards is determined based on targeted UniSource Energy Total Shareholder Return (TSR) during the performance period. The performance shares vest ratably over the performance period and any unearned awards are forfeited. Compensation expense equal to the fair value on the grant date is recognized over the vesting period if the requisite performance criteria are met.

On March 20, 2007, the Compensation Committee of the UniSource Energy Board of Directors granted 37,270 performance share awards (targeted shares) to certain officers at a grant date fair value of $35.56 per share (market price of $37.88 less the present value of expected dividends of $2.32). The performance share awards will be paid out in shares of UniSource Energy Common Stock based on UniSource Energy’s earnings per share and cash flow over the performance period of January 1, 2007 through December 31, 2009. Compensation expense equal to the fair value on the grant date is recognized over the vesting period if it is probable that the performance criteria will be met.

SHARE-BASED COMPENSATION EXPENSE

UniSource Energy and TEP recorded compensation expense of less than $0.5 million for the three months ended September 30, 2008 and 2007 and $2 million for the nine months ended September 30, 2008 and 2007. We did not capitalize any share-based compensation costs.

At September 30, 2008, the total unrecognized compensation cost related to non-vested share-based compensation was $2 million which will be recorded as compensation expense over the remaining vesting periods through March 2011. The total number of shares awarded but not yet issued, including target performance based shares, under the share-based compensation plans at September 30, 2008, was 1.8 million.

NOTE 10. FAIR VALUE MEASUREMENTS

Effective January 1, 2008, we adopted FAS 159, The Fair Value Option for Financial Assets and Financial Liabilities, which provides companies with the option of measuring certain financial assets and liabilities and other items at fair value with changes in fair value recognized in earnings as those changes occur. We have not elected fair value accounting for any of our eligible financial instruments.

Effective January 1, 2008, we adopted FAS 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. As defined in FAS 157, fair value is the price that would be received to sell an asset or paid to transfer a liability between market participants at the measurement date (exit price). FAS 157 clarifies that the exchange price is the price in the principal market in which the reporting entity would transact for the asset or liability. With limited exceptions, the provisions of FAS 157 are applied prospectively. There was no transition adjustment as a result of adopting FAS 157.

As permitted by FSP FAS 157-2 we have elected to defer the adoption of the nonrecurring fair value measurement disclosures of nonfinancial assets and liabilities, such as asset retirement obligations, until January 1, 2009.

FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active — issued October 2008, provides guidance clarifying how FAS 157 Fair Value Measures (FAS 157) should be applied in markets that are not active. The guidance reaffirms the notion of fair value as an exit price as of the measurement date. The FSP emphasizes that approaches other than the market value approach to determine fair value, such as the use of management’s internal assumptions about future cash flows and risk-adjusted discount rates, may be appropriate. The FSP, which is effective upon issuance and applicable to prior periods for which financial statements have not yet been issued, did not have a material impact on our financial statements.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

In accordance with FAS 157, we have categorized our financial instruments, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy defined by FAS 157 are as follows:


Level 1.		Financial assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market (examples include active exchange-traded equity securities and listed derivatives).


Level 2.		Financial assets and liabilities whose values are based on quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in non-active markets (examples include corporate bonds, which trade infrequently), pricing models whose inputs are observable for substantially the full term of the asset or liabilities (examples include most non-exchange-traded derivatives, including interest rate swaps), and pricing models whose inputs are derived principally from or corroborated by observable market data through correlation or other means for substantially the full term of the asset or liability.


Level 3.		Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability (examples include long-dated or complex derivatives including certain long-dated options on gas and power).

The following tables set forth, by level within the fair value hierarchy, UniSource Energy and TEP’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of September 30, 2008. As required by FAS 157, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.


	UniSource Energy
	Quoted Prices in		Significant Other			Significant
	Active Markets for		Observable			Unobservable
	Identical Assets		Inputs			Inputs
	(Level 1)		(Level 2)			(Level 3)			Total
	September 30, 2008
	- Millions of Dollars -
Assets
Investments (1)	$	45	$	12		$	12		$	69
Energy Contracts (2)		—		1			19			20

Total Assets	$	45	$	13		$	31		$	89


Liabilities
Energy Contracts (2)	$	—	$	(20	)	$	(28	)	$	(48	)
Deferred Compensation		—		(5	)		—			(5	)
Interest Rate Swap		—		(3	)		—			(3	)

Total Liabilities		—		(28	)		(28	)		(56	)

Net Total Assets and (Liabilities)	$	45	$	(15	)	$	3		$	33


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited


	TEP
	Quoted Prices in		Significant Other			Significant
	Active Markets for		Observable			Unobservable
	Identical Assets		Inputs			Inputs
	(Level 1)		(Level 2)			(Level 3)			Total
	September 30, 2008
	- Millions of Dollars -
Assets
Investments (1)	$	20	$	12		$	—		$	32
Energy Contracts (2)		—		1			17			18

Total Assets	$	20	$	13		$	17		$	50


Liabilities
Energy Contracts (2)	$	—	$	(7	)	$	(16	)	$	(23	)
Deferred Compensation		—		(5	)		—			(5	)
Interest Rate Swap		—		(3	)		—			(3	)

Total Liabilities		—		(15	)		(16	)		(31	)

Net Total Assets and (Liabilities)	$	20	$	(2	)	$	1		$	19


(1)		Level 1 investments are based on observable market prices and are comprised of the fair value of Commercial Paper and Money Market Funds. Level 2 investments comprise of amounts held in mutual and money market funds related to deferred compensation and Supplemental Executive Retirement Plan benefits. The valuation is based on observable market prices, not traded in active markets. Level 3 investments (UNS table only) are, in the absence of readily ascertainable market values, based on the investment partners’ valuations and comprise of Millennium’s equity investment in unregulated businesses.

(2)		Energy contracts include gas swap agreements (Level 2), forward power purchase and sales contracts (Level 3), and forward power purchase contracts indexed to gas (Level 3), entered into to take advantage of favorable market conditions and reduce exposure to energy price risk.

TEP, UNS Gas, UNS Electric and Millennium primarily apply the market approach for recurring fair value measurements and endeavor to utilize the best available information. Where observable inputs are available for substantially the full terms of the asset or liability, such as gas swap derivatives valued using New York Mercantile Exchange (NYMEX) pricing, adjusted for basin differences, the instrument is categorized in Level 2.

Derivatives valued using an aggregate pricing service or published prices that represent a consensus reporting of multiple brokers are categorized in Level 3. In addition, energy derivatives include contracts where published prices are not readily available. These include contracts for delivery periods during non-standard time blocks, contracts for delivery during only a few months of a given year when prices are quoted only for the annual average, or contracts for delivery at illiquid delivery points. In these cases, TEP applies certain management assumptions to value such contracts. These assumptions include applying historical price curve relationships to calendar year quotes, applying percentage multipliers to value non-standard time blocks, including the impact of counterparty credit risk, using current and historical default and recovery rates, and including adjustments for transmission and line losses to value contracts at illiquid delivery points. TEP reviews these assumptions on a quarterly basis.

TEP, UNS Gas, UNS Electric and Millennium’s assessment of the significance of a particular input to the fair value measurements requires judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

The following tables set forth a reconciliation of changes in the fair value of investments and forward power purchase and sales contracts classified as Level 3 in the fair value hierarchy:


	UniSource Energy
				-Millions of Dollars-

	Three Months Ended
	September 30, 2008
	Energy
	Commodity
	Contracts			Investments			Total
Balance as of July 1, 2008	$	30		$	12		$	42
Gains and (Losses) (realized/unrealized) Recorded to:
Other Expense		—			—			—
Purchased Energy		1			—			1
AOCI		5			—			5
Net Regulatory Liabilities		(45	)		—			(45	)
Purchases, Issuances, and Settlements		—			—			—

Balance as of September 30, 2008	$	(9	)	$	12		$	3


	UniSource Energy
	-Millions of Dollars-

	Nine Months Ended
	September 30, 2008
	Energy
	Commodity
	Contracts			Investments			Total
Balance as of January 1, 2008	$	10		$	14		$	24
Gains and (Losses) (realized/unrealized) Recorded to:
Other Expense		—			(2	)		(2	)
Wholesale Sales		(1	)		—			(1	)
Purchased Energy		(1	)		—			(1	)
AOCI		3			—			3
Net Regulatory Liabilities		(20	)		—			(20	)
Purchases, Issuances, and Settlements		—			—			—

Balance as of September 30, 2008	$	(9	)	$	12		$	3


	TEP
	-Millions of Dollars-

	Three Months			Nine Months
	Ended			Ended
	September 30,			September 30,
	2008			2008
	Energy
	Commodity Contracts
Beginning Balance	$	(5	)	$	—
Gains and (Losses) (realized/unrealized) Recorded to:
Wholesale Sales		—			(1	)
Purchased Energy		1			(1	)
AOCI		5			3
Purchases, Issuances, and Settlements		—			—

Balance as of September 30, 2008	$	1		$	1


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

All of the gains and losses disclosed in the Level 3 tables above are attributable to the change in fair value of Level 3 assets and liabilities held at the reporting date.

There were no transfers in or out of Level 3 derivatives.

NOTE 11. UNISOURCE ENERGY EARNINGS (LOSS) PER SHARE (EPS)

Basic EPS is computed by dividing Net Income (Loss) by the weighted average number of common shares outstanding during the period. Except when the effect would be anti-dilutive, the diluted EPS calculation includes the impact of shares that could be issued upon exercise of outstanding stock options, contingently issuable shares under equity-based awards or common shares that would result from the conversion of convertible notes. The numerator in calculating diluted earnings per share is Net Income (Loss) adjusted for the interest on convertible notes (net of tax) that would not be paid if the notes were converted to common shares.

The following table shows the effects of potential dilutive common stock on the weighted average number of shares:


	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2008			2007		2008			2007
	-Thousands of Dollars-					-Thousands of Dollars-
Numerator:
Net Income (Loss)	$	(11,039	)	$	25,417	$	(8,906	)	$	42,167
Assumed Conversion of Convertible Senior Notes — reduced interest expense (after-tax)		—			1,097		—			3,292

Adjusted Numerator	$	(11,039	)	$	26,514	$	(8,906	)	$	45,459


Denominator:
Weighted-average Shares of Common Stock Outstanding:
Common Shares Issued		35,453			35,286		35,398			35,250
Fully Vested Deferred Stock Units		224			228		218			219

Total Weighted-average Shares of Common Stock Outstanding		35,677			35,514		35,616			35,469
Effect of Dilutive Securities:
Convertible Senior Notes		—			4,000		—			4,000
Options and Stock Issuable under Employee Benefit Plans and the Directors’ Plan		—			528		—			583

Total Shares		35,677			40,042		35,616			40,052

For the three and nine months ended September 30, 2008, 4 million potentially dilutive shares from the conversion of convertible senior notes, and 0.5 million of options and stock issuable under employee benefit plans and the directors’ plans, were not included in the computation of diluted EPS because to do so would be anti-dilutive. For the three and nine months ended September 30, 2008, after-tax interest expense of $1 million and $3 million, respectively, was not included in the computation of diluted EPS because to do so would be anti-dilutive.

The following table shows the number of stock options to purchase shares of Common Stock excluded from the computation of diluted EPS because the stock option’s exercise price was greater than the average market price of the Common Stock:

Three Months Ended

Nine Months Ended

September 30,

2008

2007

2008

2007

-In Thousands-

Stock Options Excluded from the Diluted EPS Computation

234

234

288

148


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

NOTE 12. NEW ACCOUNTING PRONOUNCEMENTS

The FASB recently issued the following Statements of Financial Accounting Standards (FAS):

	•		FAS 161, Disclosures About Derivative Instruments and Hedging Activities an amendment to FAS 133, Accounting for Derivative Instruments and Hedging Activities, issued March 2008, requires enhanced disclosures about an entity’s derivative and hedging activity. The standard requires that the objectives for using derivative instruments be disclosed in terms of underlying risk so that the reader understands the purpose of derivative use in terms of the risks that the entity is intending to manage. The standard also requires disclosure of the location in the financial statements of derivative balances as well as the location of gains and losses incurred during the reporting period. The standard will be applicable for fiscal years or interim periods beginning on or after November 15, 2008, with early adoption encouraged. The Company is assessing the impact of this standard.

	•		FAS 160, Accounting and Reporting of Noncontrolling Interests in Consolidated Financial Statements, issued December 2007, will change the accounting and reporting for minority interests, requiring such amounts to be classified as a component of equity, and will also change the accounting for transactions with minority-interest holders. The standard will be applicable for fiscal years beginning on or after December 15, 2008 and generally on a prospective basis. Early adoption is prohibited and business combinations with acquisition dates prior to the effective date will not be adjusted upon application. We do not expect this pronouncement to have a material impact on our financial statements.

	•		FAS 141(R) Business Combinations - a replacement of FAS No. 141, issued December 2007, requires companies to record acquisitions at fair value. FAS 141(R) changes the definition of a business and a business combination and is generally expected to increase the number of transactions that will need to be accounted for at fair value. The standard will be applicable for fiscal years beginning on or after December 15, 2008 and generally on a prospective basis. Early adoption is prohibited and business combinations with acquisition dates prior to the effective date will not be adjusted upon application. We do not expect this pronouncement to have a material impact on our financial statements.

	•		FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active — issued October 2008, provides guidance clarifying how FAS 157 Fair Value Measures (FAS 157) should be applied in markets that are not active. The guidance reaffirms the notion of fair value as an exit price as of the measurement date. The FSP emphasizes that approaches other than the market value approach to determine fair value, such as the use of management’s internal assumptions about future cash flows and appropriately risk-adjusted discount rates, may be appropriate. The FSP, which is effective upon issuance and applicable to prior periods for which financial statements have not yet been issued, did not have a material impact on our financial statements.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited

NOTE 13. SUPPLEMENTAL CASH FLOW INFORMATION

A reconciliation of Net Income (Loss) to Net Cash Flows — Operating Activities follows:


	UniSource Energy
	Nine Months Ended
	September 30,
	2008			2007
	-Thousands of Dollars-

Net Income (Loss)	$	(8,906	)	$	42,167
Adjustments to Reconcile Net Income (Loss) To Net Cash Flows
Depreciation and Amortization Expense		109,196			103,494
Depreciation and Amortization Recorded to Fuel and Other O&M Expense		4,953			5,178
Amortization of Transition Recovery Asset		23,945			59,944
CTC Revenue Subject to Refund		44,415			—
Provision for Navajo Retiree Health Care and Mine Reclamation		10,080			642
Mark-to-Market Transactions		6,413			1,525
Amortization of Deferred Debt-Related Costs included in Interest Expense		2,978			2,879
Provision for Bad Debts		2,703			2,333
Deferred Income Taxes		18,079			24,830
Pension and Postretirement Expense		8,993			10,832
Pension and Postretirement Funding		(13,044	)		(12,585	)
Stock Based Compensation Expense		1,953			2,372
Excess Tax Benefit from Stock Option Exercises		(612	)		(443	)
Impairment of Millennium Investments		2,037			—
Net Unrealized Loss on MEG Trading Activities		—			1,165
Changes in Assets and Liabilities which Provided (Used)
Cash Exclusive of Changes Shown Separately
Accounts Receivable		(12,911	)		(2,051	)
Materials and Fuel Inventory		(8,458	)		(9,310	)
Over/Under Recovered Purchased Energy Cost		(13,133	)		3,515
Accounts Payable		5,774			(30,512	)
Interest Accrued		(3,286	)		(14,271	)
Income Tax Receivable/Payable		(13,151	)		(17,025	)
Taxes Other Than Income Taxes		12,479			13,670
Other		6,839			15,188

Net Cash Flows — Operating Activities	$	187,336		$	203,537


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) — Unaudited


	TEP
	Nine Months Ended
	September 30,
	2008			2007
	-Thousands of Dollars-

Net Income (Loss)	$	(15,335	)	$	39,051
Adjustments to Reconcile Net Income (Loss) To Net Cash Flows
Depreciation and Amortization Expense		93,198			88,033
Depreciation and Amortization Recorded to Fuel and Other O&M Expense		3,888			4,038
Amortization of Transition Recovery Asset		23,945			59,944
CTC Revenue Subject to Refund		44,415			—
Provision for Navajo Retiree Health Care and Mine Reclamation		10,080			642
Mark-to-Market Transactions		6,372			1,525
Amortization of Deferred Debt-Related Costs included in Interest Expense		2,166			2,004
Provision for Bad Debts		1,516			1,197
Deferred Income Taxes		6,864			15,598
Pension and Postretirement Expense		7,802			9,512
Pension and Postretirement Funding		(11,600	)		(11,430	)
Stock Based Compensation Expense		1,508			1,847
Changes in Assets and Liabilities which Provided (Used)
Cash Exclusive of Changes Shown Separately
Accounts Receivable		(25,233	)		(18,844	)
Materials and Fuel Inventory		(7,488	)		(9,596	)
Accounts Payable		19,076			(13,233	)
Interest Accrued		780			(9,846	)
Income Tax Receivable/Payable		3,298			(12,022	)
Taxes Other Than Income Taxes		11,578			13,717
Other		9,803			1,007

Net Cash Flows — Operating Activities	$	186,633		$	163,144

TEP deposited the Pima B redemption proceeds for its 7.5% collateral trust bonds with a trustee. On August 1, 2008, the deposit was applied to the payment of $128 million of principal plus $5 million of accrued interest upon maturity of the bonds.

As a result, for the three and nine months ended September 30, 2008, UniSource and TEP had a $128 million non-cash financing activity that affected recognized assets and liabilities but did not result in cash receipts or payments.

NOTE 14. REVIEW BY INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The UniSource Energy and TEP condensed consolidated financial statements as of September 30, 2008, and for the three and nine months ended September 30, 2008, and 2007, have been reviewed by PricewaterhouseCoopers LLP, an independent registered public accounting firm. Their reports (dated November 7, 2008) are included on pages 1 and 2. The reports of PricewaterhouseCoopers LLP state that they did not audit and they do not express an opinion on that unaudited financial information. Accordingly, the degree of reliance on their reports on such information should be restricted in light of the limited nature of the review procedures applied. PricewaterhouseCoopers LLP is not subject to the liability provisions of Section 11 of the Securities Act of 1933 (the Act) for their reports on the unaudited financial information because neither of those reports is a “report” or a “part” of the registration statement prepared or certified by PricewaterhouseCoopers LLP within the meaning of Sections 7 and 11 of the Act.

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 UniSource Energy and its three primary business segments and includes the following:

•

outlook and strategies,

•

operating results during the third quarter and nine months ended September 30, 2008 compared with the same periods in 2007,

•

factors which affect our results and outlook,

•

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

•

dividends, and

•

critical accounting estimates.

Management’s Discussion and Analysis should be read in conjunction with UniSource Energy and TEP’s 2007 Annual Report on Form 10-K and with the Comparative Condensed Consolidated Financial Statements, beginning on page 3, which present the results of operations for the three and nine months ended September 30, 2008 and 2007. Management’s Discussion and Analysis explains the differences between periods for specific line items of the Comparative Condensed Consolidated Financial Statements.

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

UNISOURCE ENERGY CONSOLIDATED

OVERVIEW OF CONSOLIDATED BUSINESS

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

TEP, an electric utility, has provided electric service to the community of Tucson, Arizona, for over 100 years. UES was established in 2003, when it acquired the Arizona gas and electric properties from Citizens. UES, through its two operating subsidiaries, UNS Gas, Inc. (UNS Gas) and UNS Electric, Inc. (UNS Electric), provides gas and electric service to 30 communities in Northern and Southern Arizona. These companies are regulated by the Arizona Corporation Commission (ACC).

Millennium has existing investments in unregulated businesses that represent 2% of UniSource Energy’s total assets as of September 30, 2008; no new investments are planned at Millennium. UED facilitated the expansion of the Springerville Generating Station and developed the Black Mountain Generating Station (BMGS), a natural gas-fired combustion turbine in Northern Arizona that, through a power sales agreement, is providing energy to UNS Electric.

OUTLOOK AND STRATEGIES

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

•

Obtain ACC approval of a rate increase for TEP, effective on or before January 1, 2009, that resolves the uncertainty surrounding TEP’s rates for generation service after 2008, while providing adequate revenues to cover the rising cost of serving TEP’s customers and preserving TEP’s benefits under the 1999 Settlement Agreement;

•

File requests for, and obtain ACC approval of, rate increases for UNS Gas and UNS Electric to provide adequate revenues to cover the rising cost of providing service to their customers;

•

Ensure UniSource Energy continues to have adequate liquidity by maintaining sufficient lines of credit and regularly reviewing and adjusting UniSource Energy’s short-term investment strategies in response to market conditions;

•

Efficiently manage our generation, transmission and distribution resources and seek ways to control our operating expenses while maintaining and enhancing reliability, safety and profitability;

•

Diversify TEP’s portfolio of generating and purchased power resources, along with programs to expand renewable energy sources and demand side management, to meet retail energy demand and respond to wholesale market opportunities;

•

Expand UNS Electric’s portfolio of generating and purchased power resources to meet retail energy demand;

•

Enhance the value of existing generation assets by working with SRP to support the construction of Springerville Unit 4;

•

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

•

Continue to develop synergies between UNS Gas, UNS Electric and TEP;

•

Improve UniSource Energy’s and TEP’s ratio of common equity to total capitalization; and

•

Promote economic development in our service territories.

Capital expenditures for the nine months ended September 30, 2008 were $209 million for TEP and $256 million for UniSource Energy on a consolidated basis. We expect capital expenditures for the full year 2008 to be approximately $280 million for TEP and approximately $350 million for UniSource Energy on a consolidated basis.

In our 2007 Form 10-K, we estimated TEP and UniSource Energy’s consolidated 2008 capital expenditures to be $307 million and $393 million, respectively. As a result of various factors, including moderated customer growth, we revised our estimated capital expenditures for 2008 below the projections reported in our 2007 Form 10-K.

Economic Conditions

As a result of general economic conditions, retail customer growth, and energy usage by residential and commercial customers at UniSource Energy’s utility subsidiaries is below the average levels experienced in prior periods. From 2003 to 2007, customer growth in UniSource Energy’s utility service territories averaged 2% per year for TEP, and 3% per year for UNS Gas and UNS Electric. During the three and nine month periods ended September 30, 2008, UniSource Energy’s results were impacted by slower retail customer growth and lower energy usage by residential and commercial customers. TEP experienced retail customer growth of approximately 1% and UES experienced retail customer growth of less than 1% for the twelve month period ending September 30, 2007. UniSource Energy’s future results of operations may continue to be impacted by weakening economic conditions. While we cannot predict when customer growth will return to historic levels, we expect customer growth to be approximately 1% during the next 18 months.

To date, UniSource Energy and its subsidiaries have not been materially impacted by conditions in the financial markets. Our banking relationships remain stable. UniSource Energy and its subsidiaries have access to $280 million of revolving credit facilities, of which $197 million was unused as of November 4, 2008, which we believe is sufficient to meet current operating, capital and financing needs. UniSource Energy, TEP, UNS Gas and UNS Electric have not experienced, nor do they expect to experience, any difficulties obtaining funding under their respective revolving credit facilities. None of these credit facilities have any bankrupt financial institutions as lenders, and no lenders in the bank groups have refused to fund when requested.

UniSource Energy and its subsidiaries are also subject to interest rate risk on variable rate revolving credit facility borrowings and outstanding long-term variable rate debt. See Liquidity and Capital Resources, Interest Rate Risk; Tucson Electric Power, Liquidity and Capital Resources, Interest Rate Risk; UNS Gas, Liquidity and Capital Resources, Interest Rate Risk; and UNS Electric, Liquidity and Capital Resources, Interest Rate Risk below.

Neither UniSource Energy nor any of its subsidiaries have any scheduled long-term debt maturities until 2011 when $50 million of unsecured notes mature at UNS Gas. The UniSource Energy and TEP Credit Agreements and the UNS Gas/UNS Electric Revolver also expire in 2011. UniSource Energy is required to make principal payments on an amortizing term loan, totaling $6 million per year. See UniSource Energy Credit Agreement, below.

As of November 4, 2008, TEP, UNS Electric and UNS Gas did not have any material power or gas trading exposure to financially distressed counter parties. We cannot predict whether in the future our financial condition or results of operations will be impacted by current economic conditions or liquidity concerns in the financial markets. See Liquidity and Capital Resources, below.

The pension assets are invested in a diversified portfolio of domestic and international equity securities, fixed income securities, real estate and alternative investments. As of October 31, 2008, the total value of the pension assets was approximately $141 million, compared with $190 million as of December 31, 2007. The company’s projected benefit obligation at December 31, 2007 was $209 million and will be updated as of December 31, 2008, the next measurement date for the pension plans. Due to the recent decline in the plan total asset value, 2009 funding requirements are expected to be greater than the $10 million annual contribution that we funded in 2008.

RESULTS OF OPERATIONS

Executive Overview

Third Quarter of 2008 Compared with the Third Quarter of 2007

UniSource Energy reported a net loss of $11 million in the third quarter of 2008 compared with net income of $25 million in the third quarter of 2007.

The decrease in UniSource Energy’s net income in the third quarter of 2008 is due primarily to: a $30 million provision for revenue subject to refund at TEP, partially offset by a $26 million decrease in amortization of the Transition Recovery Asset (TRA); higher fuel costs at TEP due in part to a provision for the settlement of certain mining costs at the Navajo Generating Station (Navajo), as well as unrealized losses on gas hedges; increased purchased power costs at TEP partially related to plant outages; lower retail sales at TEP due to mild weather and general economic conditions and higher maintenance costs at TEP’s generating plants. See Tucson Electric Power Company, Results of Operations, below.

Nine Months Ended September 2008 Compared with the Nine Months Ended June 2007

UniSource Energy recorded a net loss of $9 million in the first nine months of 2008 compared with net income of $42 million in the same period last year. The decrease in UniSource Energy’s net income in the first nine months of 2008 is due primarily to: a $44 million provision for revenue subject to refund at TEP, partially offset by a $36 million decrease in TRA amortization; higher coal-related fuel expense at TEP; higher purchased power costs at TEP due partially to plant outages in the first and third quarters of 2008; lower retail sales at TEP due to mild weather and general economic conditions; and a decrease in gains on the sale of SO2 emissions allowances. See Tucson Electric Power Company, Results of Operations, below.

CONTRIBUTION BY BUSINESS SEGMENT

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


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
	-Millions of Dollars-						-Millions of Dollars-
TEP	$	(12	)	$	26		$	(15	)	$	39
UNS Gas		(1	)		(2	)		5			1
UNS Electric		3			3			4			5
Other ⁽¹⁾		(1	)		(2	)		(3	)		(3	)

Consolidated Net Income	$	(11	)	$	25		$	(9	)	$	42


⁽¹⁾		Includes: UniSource Energy parent company expenses; UniSource Energy parent company interest expense (net of tax) on the UniSource Convertible Senior Notes and on the UniSource Credit Agreement; income and losses from UED; and income and losses from Millennium investments.

LIQUIDITY AND CAPITAL RESOURCES

UniSource Energy Consolidated Cash Flows


Nine Months Ended September 30,	2008			2007
	-Millions of Dollars-
Cash provided by (used in):
Operating Activities	$	187		$	204
Investing Activities		(359	)		(153	)
Financing Activities		152			(95	)

UniSource Energy’s consolidated cash flows are provided primarily from retail and wholesale energy sales at TEP, UNS Gas and UNS Electric, net of the related payments for fuel and purchased power. Generally, cash from operations is lowest in the first quarter and highest in the third quarter due to TEP’s summer peaking load. Cash used for investing activities is primarily a result of capital expenditures at TEP, UNS Gas and UNS Electric. Cash used for financing activities can fluctuate year-to-year depending on: repayments and borrowings under revolving credit facilities; debt issuances or retirements; capital lease payments by TEP; and dividends paid by UniSource Energy to its shareholders.

Liquidity

The primary source of liquidity for UniSource Energy, the parent company, is dividends from its subsidiaries, primarily TEP. Also, under UniSource Energy’s tax sharing agreement, subsidiaries make income tax payments to UniSource Energy, which makes payments on behalf of the consolidated group. The table below provides a summary of the liquidity position of UniSource Energy on a stand-alone basis and each of its segments.


				Borrowings			Amount Available
	Cash and Cash			under Revolving			under Revolving
Balances as of November 4, 2008	Equivalents			Credit Facility			Credit Facility
	-Millions of Dollars-
UniSource Energy stand-alone	$	3		$	42		$	28
TEP		39			11			139
UNS Gas		18			10	⁽¹⁾		35	⁽²⁾
UNS Electric		10			20	⁽¹⁾		25	⁽²⁾
Other		7	⁽³⁾		—			—

Total	$	77		$	83


⁽¹⁾		Includes $10 million of LOCs for UNS Gas and $12 million for UNS Electric.

⁽²⁾		Either UNS Gas or UNS Electric may borrow up to a maximum of $45 million, but the total combined amount borrowed cannot exceed $60 million.

⁽³⁾		Includes cash and cash equivalents at UED and Millennium.

Short-term Investments

UniSource Energy has a short-term investment policy which governs the investment of excess cash balances by UniSource Energy and its subsidiaries. We review this policy periodically in response to market conditions to adjust, if necessary, the maturities and concentrations by investment type and issuer in the investment portfolio. As of September 30, 2008, UniSource Energy’s short-term investments consisted of highly-rated and liquid money market funds, commercial paper, and overnight repurchase agreements. These short-term investments are classified as Cash and Cash Equivalents on the Balance Sheet.

Access to Revolving Credit Facilities

UniSource Energy, TEP, UNS Gas and UNS Electric are each party to a revolving credit agreement with a group of lenders, which is available to be used for working capital purposes. Each of these agreements is a committed facility and expires in August 2011. The TEP and UNS Gas/UNS Electric Credit Agreements may be used for revolving borrowings, as well as to issue letters of credit. TEP, UNS Gas and UNS Electric each issue letters of credit from time to time to provide credit enhancement to counterparties for their power or gas procurement and hedging activities. The UniSource Energy Credit Agreement may be used only for revolver borrowings.

UniSource Energy, TEP, UNS Gas and UNS Electric have not experienced, nor do they expect to experience, any difficulties in obtaining funding under their respective revolving credit facilities when required. None of these credit facilities have any bankrupt financial institutions as lenders, and no lenders in the bank groups have refused to fund when requested.

UniSource Energy and its subsidiaries believe that they have sufficient liquidity under their revolving credit facilities to meet their short-term working capital needs and to provide credit enhancement as may be required under their respective energy procurement and hedging agreements. See Item 3. Qualitative and Quantitative Disclosures about Market Risk, Credit Risk, below.

Executive Overview

Operating Activities

In the first nine months of 2008, net cash flows from operating activities were $16 million lower than the same period in 2007. The decrease is due primarily to payments for increased fuel and purchased power costs and operations and maintenance activities, partially offset by a tax refund, higher wholesale sales receipts, lower income taxes paid and lower interest costs paid in the first nine months of 2008.

Investing Activities

Net cash used for investing activities was $206 million higher in the first nine months of 2008 compared with the same period in 2007, due to a $133 million temporary deposit made with the trustee of maturing bonds at TEP and an increase in capital expenditures. The temporary deposit was applied by the trustee to TEP’s bonds that matured on August 1, 2008. Capital expenditures were $74 million higher in the first nine months of 2008 due primarily to utility system improvements and completion of BMGS.

Financing Activities

Net cash flows from financing activities were $247 million higher in the first nine months of 2008 compared with the same period in 2007. In March and June of 2008, The Industrial Development Authority of Pima County (Pima Authority) issued, for the benefit of TEP, approximately $91 million and $130 million, respectively, of tax-exempt industrial development revenue bonds (IDBs). Also in August 2008, UNS Electric issued $100 million of long-term debt to refinance a $60 million debt maturity and to pay down borrowings on its revolving credit facility. This increase in cash flows was offset by: TEP’s retirement of $138 million of collateral trust bonds; and higher scheduled payments on capital lease obligations by TEP.

Liquidity Outlook

Neither UniSource Energy nor any of its subsidiaries have any long-term debt maturities until 2011 when $50 million of unsecured notes mature at UNS Gas. The UniSource Energy and TEP Credit Agreements and the UNS Gas/UNS Electric Revolver also expire in 2011. UniSource Energy is required to make principal payments on an amortizing term loan, totaling $6 million per year. See UniSource Energy Credit Agreement, below.

As a result of growing capital expenditures at UniSource Energy’s subsidiaries, the revolving credit facilities at UniSource Energy, TEP, UNS Gas and UNS Electric may be used on a more frequent basis. Other funding sources to meet capital requirements could include the issuance of long-term debt, as well as capital contributions from UniSource Energy to its subsidiaries. The need for external funding sources is partially dependent on the outcome of TEP’s pending rate proceeding.

In August 2008, TEP had long-term debt maturities of $128 million which it retired with proceeds from the $130 million of IDBs issued in June 2008. See Tucson Electric Power, Liquidity and Capital Resources, Financing Activities, Bond Issuances, below.

On August 11, 2008, UNS Electric had long-term debt maturities of $60 million which it retired with proceeds from UNS Electric’s new $100 million long-term debt issued on August 7, 2008. On August 7, 2008, UNS Electric used a portion of the proceeds to repay its outstanding borrowings under the UNS Gas/UNS Electric Revolver and for general corporate purposes. See UNS Electric, Liquidity and Capital Resources, Bond Issuances, below.

For more information concerning liquidity and capital resources, see Tucson Electric Power Company, Liquidity and Capital Resources, below, UNS Gas, Liquidity and Capital Resources, UNS Electric, Liquidity and Capital Resources, and Other Non-Reportable Segments, Liquidity and Capital Resources, below.

UniSource Energy Credit Agreement

The UniSource Credit Agreement consists of a $30 million amortizing term loan facility and a $70 million revolving credit facility and matures in 2011. At September 30, 2008, there was $17 million outstanding under the term loan facility and $42 million outstanding under the revolving credit facility at a weighted average interest rate of 4.00%.

Interest Rate Risk

UniSource Energy is subject to interest rate risk resulting from changes in interest rates on its borrowings under the revolving credit facility. The interest paid on revolving credit borrowings is variable. Given the recent volatility in interest rates, UniSource Energy may be required to pay higher rates of interest on borrowings under its revolving credit facility. See Item 3. Qualitative and Quantitative Disclosures about Market Risk, Credit Risk, below.

Convertible Senior Notes

UniSource Energy has outstanding $150 million of 4.50% Convertible Senior Notes due 2035. Each $1,000 of Convertible Senior Notes is convertible into 26.943 shares of our Common Stock at any time, representing a conversion price of approximately $37.06 per share of our Common Stock, subject to adjustments. The closing price of UniSource Energy’s Common Stock was $27.36 on November 4, 2008.

Guarantees and Indemnities

•

UES’ guarantee of senior unsecured notes issued by UNS Gas ($100 million) and UNS Electric ($100 million);

•

UES’ guarantee of the $60 million UNS Gas/UNS Electric Revolver; and

•

UniSource Energy’s guarantee of approximately $2 million in building lease payments for UNS Gas.

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

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

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

Contractual Obligations

The following chart displays UniSource Energy’s consolidated contractual obligations by maturity and by type of obligation as of September 30, 2008.


UniSource Energy’s Contractual Obligations
-Millions of Dollars-
	Three
	Months
	Ended										2013
Payment Due in Years	December 31,										and
Ending December 31,	2008		2009		2010		2011		2012		after		Other		Total
Long Term Debt
Principal⁽¹⁾	$	2	$	6	$	6	$	572	$	—	$	745	$	—	$	1,331
Interest⁽²⁾		8		60		61		58		45		653		—		885
Capital Lease Obligations⁽³⁾:
Springerville Unit 1⁽⁴⁾		—		30		57		83		85		231		—		486
Springerville Coal Handling		—		15		17		19		23		55		—		129
Sundt Unit 4		—		13		14		—		—		—		—		27
Springerville Common		1		5		5		5		10		134		—		160
Operating Leases		1		2		2		1		—		2		—		8
Purchase Obligations⁽⁵⁾:
Coal and Rail Transportation⁽⁶⁾		22		99		78		44		37		216		—		496
Purchase Power⁽⁷⁾		24		133		52		19		13		16		—		257
Electric Generating Turbines		2		1		—		—		—		—		—		3
Transmission		1		5		5		3		2		7		—		23
Gas⁽⁸⁾		31		110		119		25		7		26		—		318
Other Long-Term Liabilities⁽⁹⁾:
Pension & Other Post Retirement Obligations⁽¹⁰⁾		2		5		5		6		6		32		—		56
San Juan Pollution Control Equipment⁽¹¹⁾		17		18		—		—		—		—		—		35
Acquisition of Springerville Coal Handling and Common Facilities⁽¹²⁾		—		—		—		—		—		226		—		226
Unrecognized Tax Benefits⁽¹³⁾		—		—		—		—		—		—		16		16

Total Contractual Cash Obligations	$	111	$	502	$	421	$	835	$	228	$	2,343	$	16	$	4,456


⁽¹⁾		Includes quarterly principal payments due on the term loan facility in UniSource Energy’s Credit Agreement and amounts outstanding under the UniSource Energy and UNS Electric revolving credit facilities. TEP’s variable rate IDBs are backed by letters of credit issued pursuant to TEP’s Credit Agreement, which expires in August 2011, and TEP’s 2008 Letter of Credit Facility, which expires in April 2011. Although the variable rate IDBs mature between 2018 and 2029, the above maturity reflects a redemption or repurchase of such bonds in 2011 as though the letters of credit terminate without replacement upon expiration in 2011.

⁽²⁾		Includes letter of credit and remarketing fees on variable rate debt. The interest rates for variable rate debt are estimated using Eurodollar futures rates for an approximation of LIBOR. For variable rate IDBs, a discount is applied to estimated LIBOR based on the historical discount the IDBs have had to LIBOR. Excludes interest on revolving credit facilities.

⁽³⁾		Beginning with commercial operation of Springerville Unit 3 in September 2006, Tri-State is reimbursing TEP for various operating costs related to the common facilities on an ongoing basis, including 14% of the Springerville Common Lease payments and 17% of the Springerville Coal Handling Facilities Lease payments. Similar reimbursement obligations are required after Springerville Unit 4 is constructed. TEP remains the obligor under these capital leases. Capital Lease Obligations do not reflect any reduction associated with this reimbursement.


⁽⁴⁾		Annual payments under the Springerville Unit 1 lease vary in accordance with the amortization schedules of the debt underlying the capital lease, with significantly larger principal payments occurring in 2011 and 2012.

⁽⁵⁾		Purchase obligations reflect the minimum contractual obligation under legally enforceable contracts with contract terms that are both fixed and determinable. The total amount paid under these contracts depends on the quantity purchased and transported. TEP and UES’ requirements are expected to be in excess of these minimums. UniSource Energy has excluded open purchase orders expected to be fulfilled in 2009.

⁽⁶⁾		On average, TEP expects to spend $214 million annually for the purchase and transportation of coal through 2012.

⁽⁷⁾		Includes TEP and UNS Electric’s forward power purchases.

⁽⁸⁾		Amounts include TEP, UNS Gas, and UNS Electric’s fixed price forward gas purchases and firm transportation agreements. Incremental gas purchases are excluded as prices and volumes vary. Amounts also exclude swap agreements which are marked to market on a monthly basis and do not include any minimum payment obligation.

⁽⁹⁾		Excludes TEP’s liability for final environmental reclamation at the coal mines which supply the San Juan and Four Corners as the timing of payment has not been determined. TEP estimates its undiscounted final reclamation liability is $45 million at these remote generating stations with reclamation beginning in 2028. See Note 7. Also excludes asset retirement obligations expected to occur through 2066.

⁽¹⁰⁾		These obligations represent TEP’s expected postretirement benefit costs to cover medical and life insurance claims as determined by the plans’ actuaries. TEP and UES do not know and have not included pension contributions beyond 2008 due to the significant impact that returns on plan assets and changes in discount rates might have on such amounts. TEP funds the postretirement benefit plan on a pay-as-you-go basis.

⁽¹¹⁾		These obligations represent TEP’s share of the cost of new pollution control equipment based on its ownership of San Juan. Under a settlement agreement signed in March 2005 with the New Mexico Environmental Department and environmental activist groups, the co-owners of San Juan will install new technology at the generating station to reduce mercury, particulate matter, NOx, and SO₂ emissions. In addition, TEP’s share of increased operating and maintenance costs associated with the new technologies is expected to be approximately $1 million per year over the next 10 years.

⁽¹²⁾		TEP has agreed with the owners of Springerville Units 3 and 4 that, upon expiration of the Springerville Coal Handling Facilities and Common Leases, TEP will exercise its fixed price purchase option under such lease and acquire the leased facilities. The fixed prices to acquire such facilities will be $120 million in 2015, $38 million in 2017, and $68 million in 2021. Upon such acquisitions by TEP, each of the owners of Springerville Unit 3 and Unit 4 have the obligation to purchase from TEP a 17% interest in the Springerville Coal Handling Facilities and a 14% interest in the Springerville Common Facilities.

⁽¹³⁾		As a result of adopting FIN 48 on January 1, 2007, TEP recorded a liability for uncertain tax positions. At September 30, 2008, TEP’s liability totals $16 million. TEP is unable to estimate when its liability for uncertain tax positions will be settled.

The total amount paid under these contracts depends on the quantity purchased and/or transported. TEP, UNS Electric and UNS Gas requirements are expected to be in excess of these minimums.

Dividends on Common Stock

The following table shows the dividends declared to UniSource Energy shareholders for 2008:


			Dividend Amount Per Share
Declaration Date	Record Date	Payment Date	of Common Stock
February 27, 2008	March 10, 2008	March 21, 2008	$	0.24
May 1, 2008	May 13, 2008	May 27, 2008	$	0.24
August 15, 2008	August 25, 2008	September 5, 2008	$	0.24

Income Tax Position

At September 30, 2008, UniSource Energy and TEP had, for federal and state income tax filing purposes: AMT credit carryforward amounts of $48 million and $33 million, respectively; and a $2 million Capital Loss carryforward at UniSource Energy.

TUCSON ELECTRIC POWER COMPANY

RESULTS OF OPERATIONS

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

Three Months Ended September 30

TEP recorded a net loss of $12 million in the third quarter of 2008 compared with net income of $26 million in the same period last year. The following factors contributed to the decrease in earnings:

•

A $6 million decrease in total operating revenues due to:

	•		a $7 million decrease in retail revenues due to mild summer weather and a weakening local economy;

	•		a $30 million provision for revenue subject to refund equivalent to the Fixed CTC revenue that was collected from customers when the TRA was fully amortized in early May 2008;

	•		a $27 million increase in wholesale revenues due to increased short-term wholesale activity and related purchased power volumes, lower retail demand resulting in an increase in the availability of energy to sell into the wholesale market and an increase in the market price of wholesale power. Wholesale sales volumes increased by 14% and the average price per MWh of wholesale power sold increased by 37%; and

	•		a $4 million increase in other revenues due primarily to fees and reimbursements received for fuel and O&M costs related to Springerville Units 3 and 4.

•

An increase of $59 million in fuel and purchased power expense due to:

	•		a $17 million increase in fuel expense due to higher coal-related expenses, including a $9 million provision for a settlement related to mining costs at Navajo, and a $7 million increase in unrealized losses on gas hedges;

	•		a $42 million increase in purchased power expense. Purchased power volumes increased by 33% as a result of higher short-term wholesale sales activity, while the average price paid per MWh increased by 30% due to higher market prices.

Other factors impacting the comparability of third quarter 2008 results with 2007 include:

•

a $21 million increase in O&M expense due to: a $7 million increase in generating plant maintenance, due primarily to non-recurring projects at San Juan and Springerville; a $3 million increase in O&M related to Springerville Units 3 and 4, which is reimbursed to TEP by the owners of those units and recorded in other revenues; a $3 million decrease in pre-tax gains from the sale of excess SO2 Emission Allowances which is recorded as an offset to O&M; increased transmission expense; and general cost pressures resulting from inflation and other economic factors;

•

a $26 million decrease in the amortization of TEP’s TRA. The TRA was fully amortized in May 2008; and

•

a $4 million decrease in total interest expense resulting primarily from lower balances on capital lease obligations.

In the third quarters of 2008 and 2007, the net pre-tax benefit recognized by TEP related to Springerville Units 3 and 4 for operating fees and contributions toward common facility costs was $3 million and $4 million, respectively.

Nine Months Ended September 30

TEP recorded a net loss of $15 million in the first nine months of 2008 compared with net income of $39 million in the same period last year. The following factors contributed to the decrease:

•

A $29 million increase in total operating revenues due to:

	•		a $9 million decrease in retail revenues due to mild summer weather and a weakening local economy;

	•		a $44 million provision for revenue subject to refund equivalent to the Fixed CTC revenue that was collected from customers when the TRA was fully amortized in early May 2008;

	•		a $68 million increase in wholesale revenues due to increased short-term wholesale activity and related purchased power volumes, lower retail demand resulting in an increase in the availability of energy to sell into the wholesale market and an increase in the market price of wholesale power. Wholesale sales volumes increased 23% and the average price per MWh of wholesale power sold increased by 21%; and

	•		a $14 million increase in other revenues due primarily to fees and reimbursements received for fuel and O&M costs related to Springerville Units 3 and 4.

•

A $121 million increase in fuel and purchased power due to:

	•		a $25 million increase in fuel expense due to increased coal costs, including a $9 million provision for a settlement related to mining costs at Navajo, and a 24% increase in the average cost per kWh of gas-fired generation due to higher natural gas prices; and

	•		a $96 million increase in purchased power expense. Purchased power volumes increased by 32% as a result of higher wholesale sales activity and replacement power purchases during the first and third quarters. The average price paid per MWh increased by 38% due to higher market prices for wholesale energy.

Other factors impacting the comparability of results for the first nine months of 2008 with the same period in 2007 include:

•

a $34 million increase in O&M expense due to: an $11 million increase in O&M related to Springerville Units 3 and 4, which is reimbursed to TEP by the owners of those units and recorded in other revenues; an increase in generation plant maintenance of $9 million; a $9 million decrease in pre-tax gains from the sale of excess SO2 Emission Allowances which is recorded as an offset to O&M; increased transmission expense; and general cost pressures resulting from inflation and other economic factors;

•

a $5 million increase in depreciation and amortization expense due to additions to plant in service;

•

a $36 million decrease in the amortization of TEP’s TRA. In May 2008, the TRA was fully amortized; and

•

a $10 million decrease in total interest expense resulting primarily from lower balances on capital lease obligations.

In the first nine months of 2008 and 2007, the net pre-tax benefit recognized by TEP related to Springerville Units 3 and 4 for operating fees and contributions toward common facility costs was $9 million in each period.

TEP kWh Sales and Revenues


TEP	Sales				Operating Revenue
Three Months Ended September 30,	2008		2007		2008			2007
	-Millions of kWh-				-Millions of Dollars-
Electric Retail Sales:
Residential		1,361		1,436	$	128		$	135
Commercial		613		620		64			65
Industrial		655		671		49			49
Mining		272		244		14			12
Public Authorities		65		66		5			5

Total Electric Retail Sales		2,966		3,037	$	260		$	266

Provision for Revenue Subject to Refund		—		—		(30	)		—

Net Electric Retail Sales		2,966		3,037	$	230		$	266

Electric Wholesale Sales Delivered:
Long-term Contracts		253		272		15			15
Other Sales		652		525		54			28
Transmission		—		—		4			4

Total Electric Wholesale Sales		905		797		73			47

Total Electric Sales		3,871		3,834	$	303		$	313


	2008		2007
Weather Data:
Cooling Degree Days
Three Months Ended September 30		875		1,010
10-Year Average for the third quarter		935		942


TEP	Sales				Operating Revenue
Nine Months Ended September 30,	2008		2007		2008			2007
	-Millions of kWh-				-Millions of Dollars-
Electric Retail Sales:
Residential		3,078		3,209	$	281		$	293
Commercial		1,570		1,575		163			164
Industrial		1,740		1,798		127			129
Mining		815		727		41			36
Public Authorities		193		188		15			14

Total Electric Retail Sales		7,396		7,497	$	627		$	636

Provision for Revenue Subject to Refund		—		—		(44	)		—

Net Electric Retail Sales		7,396		7,497	$	583		$	636

Electric Wholesale Sales Delivered:
Long-term Contracts		823		812		43			42
Other Sales		2,186		1,645		154			86
Transmission		—		—		12			11

Total Electric Wholesale Sales		3,009		2,457		209			139

Total Electric Sales		10,405		9,954	$	792		$	775


	2008		2007
Weather Data:
Cooling Degree Days
Nine Months Ended September 30,		1,295		1,477
10-Year Average for Nine Months Ended September 30,		1,392		1,383

Mark-to-Market Adjustments

The table below summarizes the net unrealized gains (losses) on TEP’s forward sales and purchases of power and natural gas. Amounts for 2008 are based on the market price of power and natural gas as of September 30, 2008.


	Three Months						Nine Months
Mark-to-Market Transactions — Unrealized Gain (Loss)	Ended September 30,						Ended September 30,
Recorded in Earnings	2008			2007			2008			2007
	-Millions of Dollars-
Recorded in Wholesale Sales:
Forward Power Sales	$	28		$	1		$	13		$	7
Forward Power Purchases		(28	)		—			(14	)		(7	)
Forward Power Purchases Recorded in Purchased Energy		1			(1	)		(1	)		—
Forward Gas Price Swaps Recorded in Fuel		(7	)		—			(3	)		—

Total Pre-Tax Unrealized Gain (Loss)	$	(6	)	$	—		$	(5	)	$	—

Operating Expenses

Fuel and Purchased Power Expense


	Generation and
TEP	Purchased Power						Expense
Three Months Ended September 30,	2008			2007			2008		2007
	-Millions of kWh-						-Millions of Dollars-
Coal-Fired Generation
Four Corners		213			210		$	4	$	3
Navajo		351			331			15		6
San Juan		550			628			12		14
Springerville		1,450			1,584			25		26
Sundt Unit 4		210			197			8		7

Total Coal-Fired Generation		2,774			2,950			64		56

Gas-Fired Generation
Luna		190			236			12		10
Other Gas Units		115			175			14		15

Total Gas-Fired Generation		305			411			26		25

Realized (Gains) / Losses on Gas Hedges		—			—			8		8
Unrealized (Gains) / Losses on Gas Hedges		—			—			7		—

Net Gas-Fired Generation		305			411			41		33

Solar and Other		2			1			—		—

Total Generation ⁽¹⁾		3,081			3,362			105		89

Total Purchased Power		1,086			818			100		58

Total Resources		4,167			4,180		$	205	$	147

Less Line Losses and Company Use		(296	)		(346	)

Total Energy Sold		3,871			3,834


⁽¹⁾		Fuel expense in the third quarters of 2008 and 2007 excludes $1 million related to Springerville Unit 3; these expenses are reimbursed by Tri-State and recorded in Other Revenue.

Coal-fired generation decreased by 6% compared with the third quarter of 2007, due to an unplanned outage at Springerville Unit 1 and a planned maintenance outage at San Juan Unit 1. Coal-related fuel expense increased by $8 million, or 14%, due primarily to a $9 million settlement related to mining-related costs at Navajo. See Coal Supply, below.

Gas-fired generation decreased by 26% due primarily to lower retail kWh sales; however, gas-related fuel expense increased by $8 million, due primarily to unrealized losses of $7 million in the third quarter of 2008 related to gas hedges. Higher market prices for natural gas contributed to a 39% increase in the average cost per kWh generated by TEP’s gas-fired fleet during the third quarter of 2008 compared with the same period last year.

Power purchases increased 33% compared with the third quarter of 2007. The higher purchased power volume is due primarily to higher short-term wholesale sales activity and a decrease in coal-fired generation caused by plant outages. Higher market prices for wholesale energy contributed to a 30% increase in the cost per kWh purchased. The $42 million increase in purchased power expense is partially offset by higher revenues from short-term wholesale sales.


	Generation and
TEP	Purchased Power						Expense
Nine Months Ended September 30,	2008			2007			2008		2007
	-Millions of kWh-						-Millions of Dollars-
Coal-Fired Generation
Four Corners		496			510		$	8	$	9
Navajo		979			948			27		16
San Juan		1,681			1,759			45		42
Springerville		4,330			4,388			74		73
Sundt Unit 4		585			558			21		18

Total Coal-Fired Generation		8,071			8,163			175		158

Gas-Fired Generation
Luna		543			586			37		30
Other Gas Units		179			255			26		24

Total Gas-Fired Generation		722			841			63		54

Realized (Gains) / Losses on Gas Hedges		—			—			3		8
Unrealized (Gains) / Losses on Gas Hedges		—			—			3		—

Net Gas-Fired Generation		722			841			69		62

Solar and Other		6			6			—		—

Total Generation ⁽¹⁾		8,799			9,010			244		220

Purchased Power		2,341			1,772			211		115

Total Resources		11,140			10,782		$	455	$	335

Less Line Losses and Company Use		(735	)		(828	)

Total Energy Sold		10,405			9,954


⁽¹⁾		Fuel expense in the first nine months of 2008 and 2007 excludes $4 million related to Springerville 3; these expenses are reimbursed by Tri-State and recorded in Other Revenue.

Coal-fired generation decreased by 1% compared with the first nine months of 2007, due to lower coal plant availability during the first and third quarters. Coal-related fuel expense increased by $17 million, or 11%, due primarily to higher mining-related costs at Navajo and San Juan, and increased coal costs at Sundt Unit 4. See Coal Supply, below.

Gas-fired generation decreased by 14% due primarily to mild weather in the second and third quarters of 2008. Gas-related fuel expense was $7 million, or 11%, higher than the same period last year due in part to higher market prices for natural gas. The average cost per kWh generated by TEP’s gas-fired fleet for the nine months ended September 30, 2008, increased 24% compared with the same period last year.

Power purchases increased 32% compared with the first nine months of 2007, leading to a $96 million increase in purchased power expense. The higher purchased power volume and expense is due primarily to higher short-term wholesale sales activity, replacement power purchases resulting from lower coal plant availability and an average increase in cost per kWh purchased of 39%. Higher purchased power costs are partially offset by an increase in revenues from short-term wholesale sales.

Costs per kWh

The table below summarizes TEP’s cost per kWh generated or purchased, before unrealized mark-to-market gains or losses.


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2008		2007		2008		2007
	-cents per kWh-				-cents per kWh-
Coal		2.31		1.90		2.17		1.94
Gas		11.15		8.03		9.14		7.37
Purchased Power		9.21		7.09		9.01		6.49

FACTORS AFFECTING RESULTS OF OPERATIONS

TEP Rate Proceeding

TEP Rate Proposals

Proposed Settlement Agreement

On May 29, 2008, a settlement agreement (2008 Proposed Settlement Agreement) in TEP’s rate proceeding was filed with the ACC. Parties to the 2008 Proposed Settlement Agreement include ACC Staff, Arizonans for Electric Choice and Competition, Phelps Dodge Mining Company, Arizona Community Action Association, United States Department of Defense, Arizona Investment Council, International Brotherhood of Electric Workers Local 1116, Mesquite Power, LLC, Southwestern Power Group II, LLC, Bowie Power Station, LLC, Sempra Energy Solutions and Kroger. Hearings before an ACC administrative law judge (ALJ) concluded in July 2008.

On October 28, 2008, the ALJ issued an opinion that recommends that the ACC adopt the 2008 Proposed Settlement Agreement, with new rates effective on December 1, 2008. The ALJ made recommendations on two issues not addressed by the 2008 Proposed Settlement Agreement: (i) the effective date of the rate increase and (ii) the amount or treatment of true-up revenues. The ALJ recommended that the new rates become effective December 1, 2008 and that TEP be required to credit any true-up revenues (estimated to be approximately $59 million from May 2008 to November 30, 2008) to customers through the PPFAC. See True-Up Revenues, below.

The ALJ’s recommendation is subject to approval by the ACC. The ACC scheduled a special opening meeting on November 25, 2008 to deliberate and vote on the ALJ recommended opinion and order. TEP cannot predict the outcome of ACC proceeding.

The terms of the 2008 Proposed Settlement Agreement include:

•

Base Rate Increase. A base rate increase of approximately 6% over TEP’s current retail rate of 8.4 cents per kilowatt-hour (kWh). The proposed increase will result in an increase in annual revenues of approximately $47 million, which would increase TEP’s 2006 test year base revenues of approximately $781 million to $828 million. The average cost of fuel and purchased power embedded in base rates is approximately 2.9 cents per kWh.

•

Ratemaking Methodology for Generation Assets. Rates for generation service, including Springerville Unit 1 (SGS 1) and the Luna Energy Facility (Luna), will be based on a cost-of-service methodology. For any rates in effect after 2012, all generation assets acquired by TEP after December 31, 2006 but before December 31, 2012 shall be included in TEP’s rate base at their respective original depreciated cost, subject to subsequent review by the ACC in future rate cases or other regulatory proceedings.

SGS 1 non-fuel costs will reflect a cost of $25.67 per kilowatt (kW) per month. Luna will be included in TEP’s original cost rate base at its net book value of $48 million as of December 31, 2006.

•

Cost of Capital. TEP’s capital structure for ratemaking purposes will be comprised of 57.5% debt and 42.5% common equity. TEP’s allowed return on equity will be 10.25% and the embedded cost of debt will be 6.38% for ratemaking purposes.

•

Depreciation and Net Negative Salvage. Upon the effective date of an ACC order approving the 2008 Proposed Settlement Agreement, TEP will implement new depreciation rates that include: a component for net negative salvage value for all generation assets except Luna; and new depreciation rates for distribution and general plant assets that will extend the depreciable lives of these assets. The change in depreciation rates will result in an increase in depreciation expense of approximately $11 million per year, based on a December 31, 2006 test year.

•

Implementation Cost Recovery Asset and Coal Costs. TEP’s original cost rate base will include an Implementation Cost Recovery Asset (ICRA) of $14 million to reflect costs incurred by TEP to transition to competition under the 1999 Settlement Agreement. For ratemaking purposes, the ICRA will be amortized over a four-year period.

The 2008 Proposed Settlement Agreement will also allow TEP to recover, over a nine-year period, approximately $9 million of costs related to the renegotiation in 2000 of a coal contract for the San Juan Generating Station.

The approval of the 2008 Proposed Settlement Agreement will cause TEP to be subject to the accounting provisions of FAS 71 for its generation operations, which, among other things, would cause TEP to record additional assets and recognize income of $11 million related to the ICRA and San Juan coal costs. As TEP applies FAS 71, other adjustments may be required.

•

Purchased Power and Fuel Adjustor Clause. The purchased power and fuel adjustor clause (PPFAC) will be effective starting January 1, 2009. The PPFAC allows recovery of demand charges and the cost of contracts for hedging fuel and purchased power costs. The PPFAC will consist of a forward component and a true-up component.

•

The forward component will be updated on April 1 of each year, starting in 2009. The forward component will be the forecasted fuel and purchased power costs for the 12-month period from April 1 to March 31, less the embedded base cost of fuel and purchased power of 2.9 cents per kWh. During this 12-month period, TEP will have the ability to request an adjustment to the forward component should an extraordinary event occur that causes a drastic change in forecasted fuel and purchased power costs.

•

The true-up component will reconcile any over/under collected amounts from the preceding 12-month period and will be credited to or recovered from customers in the subsequent year.

TEP will credit the following against the PPFAC: 100% of short-term wholesale revenues; 50% of the revenues from the sales of sulfur dioxide (SO2) emission allowances; and 10% of TEP’s positive wholesale trading profits.

Based on current market prices, the PPFAC charge could increase average residential customers’ bills by another 3 to 4 percent in 2009.

•

Renewable Energy and Demand-Side Management Adjustors. TEP’s new rates will include the Renewable Energy Standard Tariff (REST) adjustor mechanism approved by the ACC in April 2008. See Renewable Energy Standard and Tariff, below. A demand-side management (DSM) adjustor mechanism will provide initial funding of $6 million for DSM programs. TEP will file for ACC approval to reset the DSM adjustor rate by April 1 of each year.

•

Base Rate Increase Moratorium. TEP’s base rates will be frozen through December 31, 2012. TEP will be prohibited from submitting a base rate application before June 30, 2012. The test year to be used in TEP’s next base rate application must be no earlier than December 31, 2011. Notwithstanding the rate increase moratorium, base rates and adjustor mechanisms may be changed in emergency conditions which are beyond TEP’s control if the ACC concludes such changes are required to protect the public interest. TEP will not be precluded from seeking rate relief in the event of the imposition of a federal carbon tax or related federal carbon regulations.

•

1999 Settlement Agreement. All of TEP’s rights and claims under the 1999 Settlement Agreement would be waived if the proposed settlement agreement is approved by the ACC without any significant modifications.

If TEP does not receive adequate rate relief from the ACC: (i) all of TEP’s legal rights and claims arising out of the 1999 Settlement Agreement and the decision approving the 1999 Settlement Agreement would be fully preserved; (ii) TEP’s results of operations, net income and cash flows could be negatively impacted; and (iii) TEP may initiate legal proceedings against (a) the ACC, and other parties, for breach of the 1999 Settlement Agreement and (b) the ACC for inadequate rates. The proposed settlement agreement is subject to ACC approval. TEP cannot predict the outcome of the rate case proceedings.

True-up Revenues

According to a May 2007 ACC order, TEP’s current retail rates shall remain in effect, including the collection of an amount equal to the Fixed Competitive Transition Charge (CTC), until the effective date of a final order in the rate case proceeding. Under the 1999 Settlement Agreement, collection of the Fixed CTC terminated in May 2008 when the TRA balance was amortized to zero. The incremental revenues (true-up revenues) collected as a result of continuing to collect an amount equal to the Fixed CTC (estimated to be $65 million from May 2008 to December 31, 2008) shall accrue interest and shall be subject to refund or credit or other such mechanism to protect customers, as determined by the ACC.

As of September 30, 2008, TEP had collected $44 million of true-up revenues which were recorded as a provision for revenue subject to refund. TEP will continue to record the true-up revenues as a provision for revenue subject to refund until the ACC issues a final order that authorizes TEP to retain any incremental revenues. The opinion issued by the ALJ on October 28, 2008 recommends that the ACC credit all of the true-up revenues collected from May 2008 through November 30, 2008 (estimated to be approximately $59 million) to customers through the PPFAC. See Proposed Settlement Agreement, above.

Renewable Energy Standard and Tariff

In April 2008, the ACC approved a REST plan for TEP to be implemented starting on June 1, 2008. The plan is based on an ACC Staff recommendation that will result in $14 million collected annually from customers to pay for REST compliance costs. The funds received from customers under the REST plan will be used to offset costs incurred by TEP under the REST plan.

FERC Proceeding

TEP is a party to a proceeding pending at FERC involving the interpretation of the 1982 Power Exchange and Transmission Agreement (1982 Agreement) between TEP and El Paso Electric (El Paso). The dispute relates to TEP’s ability to use existing rights for the transmission of power from Luna to TEP’s system. On September 6, 2007, a FERC ALJ issued an initial decision, subject to full FERC review, that supports TEP’s position.

As part of this proceeding, TEP has requested that FERC order El Paso to refund transmission charges paid by TEP during the pendency of this dispute proceeding. These refunds include $3.5 million paid to El Paso in 2006, $3 million paid to El Paso in 2007, $4 million in the first nine months of 2008, as well as any additional disputed transmission purchased prior to FERC issuing its final order. TEP expects FERC to issue its final order in fourth quarter of 2008.

TEP cannot predict the outcome of this proceeding.

Market Prices

As a participant in the Western U.S. wholesale power markets, TEP is directly and indirectly affected by changes in market conditions. The average market price for around-the-clock energy based on the Dow Jones Palo Verde Index was 25% higher in the third quarter of 2008 compared with the same period last year. The average price for natural gas based on the Permian Index was 59% higher than the third quarter of 2007. We cannot predict whether changes in various factors that influence demand and supply will cause prices to change for the remainder of 2008.


Average Market Price for Around-the-Clock Energy	$/MWh
Quarter ended September 30, 2008	$	69
Quarter ended September 30, 2007		55

Nine months ended September 30, 2008	$	71
Nine months ended September 30, 2007		53


Average Market Price for Natural Gas	$/MMBtu
Quarter ended September 30, 2008	$	8.68
Quarter ended September 30, 2007		5.47

Nine months ended September 30, 2008	$	8.47
Nine months ended September 30, 2007		6.13

Short-term and spot power purchase prices are also closely correlated to natural gas prices. Due to its increasing seasonal gas and purchased power usage, TEP hedges a portion of its total natural gas exposure from plant fuel and gas-indexed purchased power with fixed price contracts for a maximum of three years. TEP had approximately 30% of this exposure hedged for the 2009 peak season (June — September) at a weighted average price of $8.40 per MMBtu. TEP purchases its remaining gas fuel needs and purchased power in the spot and short-term markets.

Market prices may also affect TEP’s wholesale revenues. For the fourth quarter of 2008, TEP has sold forward approximately 209,000 MWh at an average price of $66 per MWh.

Coal Supply

In the third quarter of 2008, TEP entered into agreements for the purchase and transportation of coal to Sundt Unit 4 through 2009. The cost of coal and transportation under these agreements will increase approximately 24%, primarily due to higher coal costs. Based on these agreements, and increases at other coal-fired plants, we expect TEP’s total coal-related fuel expense across all of its plants to increase by approximately 5% or $12 million in 2009, compared with 2008.

Generating Plant Operating Performance

In February 2008, Springerville Unit 1 incurred a partial collapse of one of four scrubber modules. Structural inspections revealed that repairs were required on various scrubber modules on both Springerville Units 1 and 2. The generating capacity of Springerville Units 1 and 2 are 380 MW and 390 MW, respectively. During the inspection period in February and March 2008, the output of Springerville Units 1 and 2 was each reduced by 10-15 MW.

The repair work was completed on both units in May 2008. During the module repair process, the output from Springerville Unit 2 was reduced by 10 MW. A significant portion of the repair cost is expected to be covered by insurance.

On September 24, 2008, Springerville Unit 1 was taken out of service for 16 days due to a mechanical problem with the intermediate pressure turbine. The length of the outage was reduced due to the on-sight availability of spare turbine parts. The Springerville Unit 1 intermediate pressure turbine is scheduled to be replaced during a planned maintenance outage in early 2009. The outage cost an estimated $5 million, pre-tax. The cost includes replacement power costs, estimated lost wholesale sales opportunities and approximately $0.5 million of O&M expense to repair the unit.

Emission Allowances

TEP has SO₂ Emission Allowances in excess of what is required to operate its generating units. The excess results primarily from a higher removal rate of SO₂ emissions at Springerville Units 1 and 2 following recent upgrades to environmental plant components and related changes to plant operations. From time to time, TEP will sell a portion of its excess SO₂ Emission Allowances. The table below summarizes sales of SO₂ Emission Allowances made in 2007. TEP did not sell any SO₂ Emission Allowances in the first or third quarters of 2008 and had no forward sales as of September 30, 2008.


Delivery	Allowances Sold		Pre-tax Gain
			-Millions-
2007
1^st Quarter		2,500	$	2
2^nd Quarter		7,500		5
3^rd Quarter		5,000		3
4^th Quarter		7,000		5

Total 2007		22,000	$	15


2008
2^nd Quarter		4,000		1

Total 2008		4,000	$	1

TEP expects to have approximately 13,000 excess SO₂ Emission Allowances through 2009.

On July 11, 2008, a U.S. Court of Appeals decision invalidated certain EPA regulations that would have required the reduction of SO₂ emissions starting in 2010 in several Midwestern and eastern states. As a result, the market value of SO₂ Emission Allowances has significantly declined.

Fair Value Measurements

As described in Note 10 to the financial statements, TEP adopted FAS 157, Fair Value Measurements, on January 1, 2008 which, among other things, establishes a three-tier value hierarchy, based on the valuation techniques used to determine the fair value of derivative assets and liabilities. Where valuations are based on quoted prices in active markets these are categorized as Level 1. Where observable inputs are available for substantially the full terms of the asset or liability, the instrument is categorized under FAS 157 as Level 2 measurements. Derivatives that are primarily valued using an aggregate pricing service or published prices that represent a consensus reporting of multiple brokers are categorized in Level 3. In addition, complex or structured transactions can introduce the need for internally-developed model inputs that might not be observable in or corroborated by the market. When such inputs have a significant impact on the measurement of fair value, the instrument is categorized under FAS 157 as Level 3 measurements.

The following table sets forth, by level within the fair value hierarchy, TEP’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of September 30, 2008. As required by FAS 157, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.


Tucson Electric Power
September 30, 2008
- Millions of Dollars -
	Quoted Prices in
	Active Markets		Significant Other			Significant
	for Identical		Observable			Unobservable
	Assets (Level 1)		Inputs (Level 2)			Inputs (Level 3)		Total
Investments ⁽¹⁾	$	20	$	12		$	—	$	32
Energy Contracts ⁽²⁾		—		(6	)		1		(5	)
Deferred Compensation		—		(5	)		—		(5	)
Interest Rate Swap		—		(3	)		—		(3	)

Total	$	20	$	(2	)	$	1	$	19


(1)		Level 1 investments are based on observable market prices and comprise of the fair value of Commercial Paper and Money Market Funds. Level 2 investments comprise of amounts held in mutual and money market funds related to deferred compensation and Supplemental Executive Retirement Plan benefits. The valuation is based on observable market prices, not traded in active markets.

(2)		Energy contracts include gas swap agreements (Level 2), forward power purchase and sales contracts (Level 3), and forward power purchase contracts indexed to gas (Level 3), entered into to take advantage of favorable market conditions and reduce exposure to energy price risk. The amounts include current and non-current assets and are net of current and non-current liabilities.

For the three months ended September 30, 2008, TEP recorded unrealized gains of $1 million in the Purchased Energy line of the income statement and unrealized gains of $5 million in Accumulated Other Comprehensive Income (AOCI) due to the change in the fair value of forward power purchase and sale contracts classified as Level 3 in the fair value hierarchy. TEP recorded in the nine months ended September 30, 2008, unrealized losses of $1 million in the Purchased Energy line of the income statement, unrealized losses of $1 million in the Wholesale Sales line of the income statement and unrealized gains of $3 million in AOCI. The changes in fair value were due to higher gas prices on gas-indexed forward power purchases.

TEP values its energy derivative contracts by obtaining market quotes for periods and delivery points where an active market exists. For both power and gas prices, TEP obtains quotes from brokers, major market participants, exchanges or industry publications. TEP primarily uses one set of quotations each for power and for gas, and then use the other sources as validation of those prices. The broker providing quotes for power prices states that the market information provided is indicative only, but believes it to be reflective of market conditions as of the time and date indicated.

TEP’s Level 3 derivatives include certain energy contracts where published prices are not readily available. These include contracts for delivery periods during non-standard time blocks, contracts for delivery during only a few months of a given year when prices are quoted only for the annual average, or contracts for delivery at illiquid delivery points. In these cases, TEP applies certain management assumptions to value such contracts. These assumptions include applying historical price curve relationships to calendar year quotes, applying percentage multipliers to value non-standard time blocks, including a combination of market credit default swap data and historical recovery rates for subordinated bonds and including adjustments for transmission and line losses to value contracts at illiquid delivery points. TEP reviews these assumptions on a quarterly basis.

Regional Haze

LIQUIDITY AND CAPITAL RESOURCES

TEP Cash Flows

During 2008, TEP expects to generate sufficient internal cash flows to fund a portion of its construction expenditures as well as operating activities, required debt maturities and dividends to UniSource Energy. Cash flows may vary during the year, with cash flow from operations typically the lowest in the first quarter and highest in the third quarter due to TEP’s summer peaking load. As a result of the varied seasonal cash flow, TEP will use, as needed, its revolving credit facility to fund its business activities.

The table below shows TEP’s net cash flows after capital expenditures, scheduled debt payments and payments on capital lease obligations which are paid at the beginning of January and July:


Nine Months Ended September 30,	2008			2007
	-Millions of Dollars-
Net Cash Flows — Operating Activities (GAAP)	$	187		$	163
Amounts from Statements of Cash Flows:
Less: Capital Expenditures		(209	)		(123	)

Net Cash Flows after Capital Expenditures (non-GAAP)*		(22	)		40
Amounts from Statements of Cash Flows:
Less: Retirement of Capital Lease Obligations		(74	)		(71	)
Plus: Proceeds from Investment in Lease Debt		25			28

Net Cash Flows after Capital Expenditures and Required Payments on Capital Lease Obligations (non-GAAP)*	$	(71	)	$	(3	)


Nine Months Ended September 30,	2008			2007
	-Millions of Dollars-
Net Cash Flows — Operating Activities (GAAP)	$	187		$	163
Net Cash Flows — Investing Activities (GAAP)		(313	)		(97	)
Net Cash Flows — Financing Activities (GAAP)		133			(75	)
Net Cash Flows after Capital Expenditures (non-GAAP)*		(22	)		40
Net Cash Flows after Capital Expenditures and Required Payments on Capital Lease Obligations (non-GAAP)*	$	(71	)	$	(3	)


*		Net Cash Flows after Capital Expenditures and Net Cash Flows after Required Payments, both non-GAAP measures of liquidity, should not be considered as alternatives to Net Cash Flows - Operating Activities, which is determined in accordance with GAAP as a measure of liquidity. We believe that Net Cash Flows after Capital Expenditures and Net Cash Flows after Required Payments provide useful information to investors as measures of TEP’s liquidity and ability to fund capital requirements, make required payments on capital lease obligations and pay dividends to UniSource Energy.

In the first nine months of 2008, TEP’s capital expenditures and payments on capital lease obligations exceeded operating cash flows by $71 million. The shortfall was initially funded with borrowings under TEP’s revolving credit facility. These revolving credit facility borrowings were repaid with proceeds from the issuance of the 2008 Pima A Bonds. See Bond Issuances, below.

Liquidity Outlook

As a result of growing capital expenditures, TEP may use its revolving credit facility on a more frequent basis. Other funding sources to meet the capital requirements could include the issuance of long-term debt as well as capital contributions from UniSource Energy. The need for external funding sources is partially dependent on the outcome of TEP’s rate proceedings. See Outlook and Strategies, Economic Conditions and UniSource Energy Liquidity and Capital Resources, Liquidity, Access to Revolving Credit Facilities, above for more information regarding the potential impact of current financial market conditions.

On August 1, 2008, $128 million of maturing TEP collateral trust bonds with a coupon of 7.5% were retired. TEP retired the maturing debt with the proceeds from the issuance of $130 million of IDBs in June 2008. See Financing Activities, Bond Issuances, below.

Operating Activities

In the first nine months of 2008, net cash flows from operating activities increased by $23 million compared with the same period in 2007. Net cash flows were impacted by:

	•		a $36 million decrease in cash receipts from retail and wholesale electric sales, less fuel and purchased power costs, resulting from higher coal-related fuel costs, mild weather, general economic conditions and unplanned outages during the first quarter that limited wholesale sales opportunities;

	•		a $13 million increase in cash receipts related to reimbursements received for the operation of Springerville Unit 3 and 4;

	•		income tax refunds of $18 million;

	•		an $8 million decrease in proceeds from the sale of excess SO2 emission allowances;

	•		a $19 million decrease in total interest paid due to lower capital lease obligation balances; and

	•		a $24 million decrease in income taxes paid due to lower taxable income and payments made last year for amended tax returns.

Investing Activities

Net cash used for investing activities was $216 million higher in the first nine months of 2008 compared with the same period last year primarily due to: an $86 million increase in capital expenditures due to the maintenance and growth of TEP’s utility system; and the deposit of $133 million by TEP with the trustee for the first collateral trust bonds that matured on August 1, 2008.

Financing Activities

Net cash proceeds from financing activities were $209 million higher in the first nine months of 2008 compared with the same period in 2007. The following factors contributed to the increase:

	•		proceeds of $221 million received by TEP related to the issuance of tax-exempt IDB’s through the Pima County Industrial Development Authority;

	•		a $14 million increase in net proceeds from borrowings under the TEP Revolving Credit Facility; partially offset by

	•		$10 million of long-term debt repayments.

TEP Credit Agreement

The TEP Credit Agreement consists of a $150 million revolving credit facility and a $341 million letter of credit facility which supports $329 million of tax-exempt variable rate bonds. The TEP Credit Agreement is a committed facility that matures in 2011 and is secured by $491 million of 1992 Mortgage Bonds. At September 30, 2008, there were $10 million in outstanding loans under the revolving credit facility and there were no letters of credit issued under the revolving credit facility. TEP does not anticipate any funding issues from its lenders in the event it needs to access its revolving credit facility.

Bond Issuances

On March 19, 2008, The Pima Authority issued approximately $91 million of its 2008 Series A tax-exempt IDBs (2008 Pima A Bonds) for TEP’s benefit. The proceeds were used to redeem a corresponding principal amount of bonds previously issued by the Pima Authority for TEP’s benefit which TEP repurchased in 2005. TEP did not cancel the repurchased bonds, which remained outstanding under their respective indentures but were not reflected as debt on the balance sheet. As holder of the repurchased bonds being redeemed, TEP received the payment of the redemption price. TEP used $75 million of the proceeds to repay loans outstanding under its revolving credit facility and $10 million to redeem a portion of TEP’s collateral trust bonds that matured on August 1, 2008.

The 2008 Pima A Bonds are unsecured, bear interest at the rate of 6.375%, mature on September 1, 2029 and are callable at par in March 2013.

On June 25, 2008, the Pima Authority issued $130 million of its 2008 Series B tax-exempt IDBs (2008 Pima B Bonds) for TEP’s benefit. The proceeds were used to redeem a corresponding principal amount of bonds previously issued by the Pima Authority for TEP’s benefit which TEP repurchased in 2005. TEP did not cancel the repurchased bonds, which remained outstanding under their respective indentures but were not reflected as debt on the balance sheet. As holder of the repurchased bonds being redeemed, TEP received the payment of the redemption price. TEP used $128 million of the proceeds to redeem the remaining 7.5% collateral trust bonds that matured on August 1, 2008. The 2008 Pima B Bonds are supported by a letter of credit (LOC) issued under a $132 million LOC and Reimbursement Agreement dated April 30, 2008 among TEP, the LOC issuing bank and a group of lenders.

Interest Rate Risk

TEP is exposed to interest rate risk resulting from changes in interest rates on certain of its variable rate debt obligations, as well as borrowings under its revolving credit facility. As a result, TEP may be required to pay significantly higher rates of interest on outstanding variable rate debt and borrowings under its revolving credit facility. At September 30, 2008 and December 31, 2007, TEP had $459 million and $329 million in tax-exempt variable rate debt outstanding. The increase in 2008 is due to the issuance of $130 million of 2008 Pima B Bonds in June 2008. The interest rates on TEP’s tax-exempt variable rate debt are reset weekly by its remarketing agents. The maximum interest payable under the indentures for the bonds is 10% on the $130 million of 2008 Pima B Bonds and 20% on the other $329 million in IDBs During 2008, the average rates paid have ranged from 1.15% to 8.09%. At November 4, 2008, the average rate on the debt was 1.72%. See Item 3. Qualitative and Quantitative Disclosures about Market Risk, Interest Rate Risk, below.

Capital Lease Obligations

At September 30, 2008, TEP had $529 million of total capital lease obligations on its balance sheet. The table below provides a summary of the outstanding lease amounts in each of the obligations.


	Capital Lease Obligation Balance
Leased Asset	at September 30, 2008		Expiration
	-In Millions-
Springerville Unit 1	$	307		2015
Springerville Coal Handling Facilities		91		2015
Springerville Common Facilities		106		2020
Sundt Unit 4		25		2011

Total Capital Lease Obligations	$	529

Except for TEP’s 14% equity ownership in the Springerville Unit 1 Leases and its 13% equity ownership in the Springerville Coal Handling Facilities, TEP will not own these assets at the expiration of the leases. TEP will either renew the leases or purchase the leased assets at such time. The renewal and purchase options for Springerville Unit 1 and Sundt Unit 4 are generally for fair market value as determined at that time, while the purchase price option is fixed for the Springerville Coal Handing Facilities and Springerville Common Facilities. The owners of Springerville Units 3 and 4 have the option to purchase a pro rata share of the Springerville Coal Handling and Common Facilities when those leases expire.

Investments in Springerville Lease Debt and Equity

At September 30, 2008, TEP had $127 million of investments in lease debt and equity on its balance sheet. TEP’s investment in lease debt has been reduced by scheduled payments on capital lease obligations. The yields on TEP’s investments in Springerville lease debt, at the date of purchase, range from 8.9% to 12.7%. The table below provides a summary of the investment balances in lease debt.


	Lease Debt Investment Balance
Leased Asset	September 30, 2008		December 31, 2007
	-In Millions-
Investments in Lease Debt:
Springerville Unit 1	$	59	$	71
Springerville Coal Handling Facilities		20		34

Total Investment in Lease Debt	$	79	$	105

Income Tax Position

See UniSource Energy, Liquidity and Capital Resources, Income Tax Position, above.

Contractual Obligations

The following chart displays TEP’s contractual obligations as of September 30, 2008 by maturity and by type of obligation.


TEP’s Contractual Obligations
-Millions of Dollars-
	Three
	Months
	Ended										2013
Payment Due in Years	December										and
Ending December 31,	31, 2008		2009		2010		2011		2012		after		Other		Total
Long Term Debt

Principal	$	—	$	—	$	—	$	469	$	—	$	445	$	—	$	914
Interest		8		40		41		38		28		443		—		598
Capital Lease Obligations:
Springerville Unit 1		—		30		57		83		85		231		—		486
Springerville Coal Handling		—		15		17		19		23		55		—		129
Sundt Unit 4		—		13		14		—		—		—		—		27
Springerville Common		1		5		5		5		10		134		—		160
Operating Leases		1		1		1		—		—		—		—		3
Purchase Obligations:
Coal and Rail Transportation		22		99		78		44		37		216		—		496
Purchase Power		9		49		3		3		3		5				72
Transmission		—		2		2		2		1		7		—		14
Gas		4		41		74		6		4		1		—		130
Other Long-Term Liabilities:
Pension & Other Post Retirement Obligations		2		5		5		6		6		31		—		55
San Juan Pollution Control Equipment		17		18		—		—		—		—		—		35
Acquisition of Springerville Coal Handling and Common Facilities		—		—		—		—		—		226		—		226
Unrecognized Tax Benefits		—		—		—		—		—		—		16		16

Total Contractual Cash Obligations	$	64	$	318	$	297	$	675	$	197	$	1,794	$	16	$	3,361

Dividends on Common Stock

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

TEP can pay dividends if it maintains compliance with the TEP Credit Agreement and certain financial covenants. As of September 30, 2008, TEP was in compliance with the terms of the TEP Credit Agreement and such financial covenants.

UNS GAS

RESULTS OF OPERATIONS

UNS Gas reported a net loss of $1 million in the third quarter of 2008 and a net loss of $2 million in same period of 2007. The table below shows UNS Gas’ therm sales and revenues for the first quarters of 2008 and 2007.


	Sales				Revenue
Three Months Ended September 30,	2008		2007		2008		2007
	-Millions of Therms-				-Millions of Dollars-
Retail Therm Sales:
Residential		5		5	$	10	$	9
Commercial		4		4		5		4
Industrial		—		—		—		—
Public Authorities		1		1		—		1

Total Retail Therm Sales		10		10		15		14
Transport		—		—		1		—
Negotiated Sales Program (NSP)		7		3		7		2

Total Therm Sales		17		13	$	23	$	16

Retail therm sales were flat in the third quarter of 2008 compared with the same period last year due to customer growth of less than 1% since September 2007. Retail revenues were $1 million, or 7% higher due primarily to the impact of a base rate increase averaging 4% that went into effect in December 2007. See Factors Affecting Results of Operations, Rates and Regulation, Purchased Gas Adjustment Mechanism, below.

Through a Negotiated Sales Program (NSP) approved by the ACC, customers who receive gas transmission services from UNS Gas may also elect to purchase gas from UNS Gas. Approximately one half of the margin earned on these NSP sales is retained by UNS Gas, while the remainder benefits retail customers through a credit to the PGA mechanism which reduces the gas commodity price. See Factors Affecting Results of Operations, Rates and Regulation, Energy Cost Adjustment Mechanism, below.

The table below provides summary financial information for UNS Gas.


Three Months Ended September 30,	2008			2007
	-Millions of Dollars-
Gas Revenues	$	23		$	16
Other Revenues		1			1

Total Operating Revenues		24			17

Purchased Gas Expense		15			10
Other Operations and Maintenance Expense		6			6
Depreciation and Amortization		2			2
Taxes other than Income Taxes		1			1

Total Other Operating Expenses		24			19


Operating Income		—			(2	)

Other Income		—			—
Total Interest Expense		2			2
Income Tax Expense (Benefit)		(1	)		(2	)

Net Income	$	(1	)	$	(2	)

Nine Months Ended September 30, 2008 Compared with the Nine Months Ended September 30, 2007

UNS Gas reported net income of $5 million in the first nine months of 2008, compared with net income of $1 million in 2007.

The table below shows UNS Gas’ therm sales and revenues for the nine months ending September 30, 2008 and 2007.


	Sales				Revenue
Nine Months Ended September 30,	2008		2007		2008		2007
	-Millions of Therms-				-Millions of Dollars-
Retail Therm Sales:
Residential		50		48	$	67	$	62
Commercial		22		21		25		23
Industrial		1		1		1		1
Public Authorities		5		4		5		5

Total Retail Therm Sales		78		74		98		91
Transport		—		—		3		2
Negotiated Sales Program (NSP)		21		13		19		8

Total Therm Sales		99		87	$	120	$	101

Retail therm sales were 5% higher in the first nine months of 2008 compared with the same period last year, due primarily to cold weather during the first quarter. Retail revenues were $7 million, or 8% above 2007, due to higher therm sales and a base rate increase of 4% effective December 1, 2007. See Factors Affecting Results of Operations, Rates and Regulation, Energy Cost Adjustment Mechanism, below.

The table below provides summary financial information for UNS Gas.


Nine Months Ended September 30,	2008		2007
	-Millions of Dollars-
Gas Revenues	$	120	$	101
Other Revenues		2		2

Total Operating Revenues		122		103

Purchased Gas Expense		83		69
Other Operations and Maintenance Expense		18		20
Depreciation and Amortization		5		6
Taxes other than Income Taxes		2		2

Total Other Operating Expenses		108		97


Operating Income		14		6

Other Income		—		1
Total Interest Expense		5		5
Income Tax Expense (Benefit)		4		1

Net Income	$	5	$	1

FACTORS AFFECTING RESULTS OF OPERATIONS

RATES AND REGULATION

Energy Cost Adjustment Mechanism

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

The current PGA mechanism has two components, the PGA factor and the PGA surcharge or credit. The PGA factor is a mechanism that compares the twelve-month rolling weighted average gas cost to the base cost of gas, and automatically adjusts monthly, subject to limitations on how much the price per therm may change in a twelve month period. In November 2007, the ACC increased the annual cap on the maximum increase in the PGA factor from $0.10 per therm to $0.15 per therm in a twelve month period. In addition, the ACC set the base cost of gas at zero, so that the entire cost of gas will be reflected in the PGA factor. Previously, the base cost of gas was $0.40 per therm.

At any time UNS Gas’ PGA bank balance is under-recovered, UNS Gas may request a PGA surcharge with the goal of collecting the amount deferred from customers over a period deemed appropriate by the ACC. When the PGA bank balance reaches an over-collected balance of $10 million on a billed to customers basis, UNS Gas is required to make a filing so that the ACC can determine how the over-collected balance should be returned to customers. On September 30, 2008, the PGA bank balance was over-collected by $2 million on a billed to customers basis ($4 million on an accrual (GAAP) basis).

Changes in the market price for gas, sales volumes and surcharge amount could significantly change the PGA bank balance in the future.

2008 General Rate Case Filing

Due to increases in capital and operating costs related to providing safe and reliable service to customers of UNS Gas, UNS Gas believes the rates approved by the ACC in 2007 are inadequate for UNS Gas to recover its costs and earn a reasonable return on its investments.

On November 7, 2008, UNS Gas filed a general rate case with the ACC on a cost of service basis. Below is a table that summarizes UNS Gas’ request:


Test year — 12 months ended June 30, 2008		Requested by UNS Gas
Original cost rate base		$182 million
Fair value rate base		$256 million
Revenue deficiency		$9.5 million
Total rate increase (over test year revenues)		6%
Cost of long-term debt		6.5%
Cost of equity		11.0%
Actual capital structure		50% equity / 50% debt
Weighted average cost of capital		8.75%
Rate of return on fair value rate base		6.80%

Fair Value Measurements

UNS Gas adopted FAS 157, Fair Value Measurements, on January 1, 2008 which, among other things, establishes a three-tier value hierarchy, based on the valuation techniques used to determine the fair value of derivative assets and liabilities. Where valuations are based on quoted prices in active markets these are categorized as Level 1. Where observable inputs are available for substantially the full terms of the asset or liability, the instrument is categorized under FAS 157 as Level 2 measurements. Derivatives that are primarily valued using an aggregate pricing service or published prices that represent a consensus reporting of multiple brokers are categorized in Level 3. In addition, complex or structured transactions can introduce the need for internally-developed model inputs that might not be observable in or corroborated by the market. When such inputs have a significant impact on the measurement of fair value, the instrument is categorized under FAS 157 as Level 3 measurements.

The following table sets forth, by level within the fair value hierarchy, UNS Gas’ financial assets and liabilities that were accounted for at fair value on a recurring basis as of September 30, 2008. As required by FAS 157, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.


UNS Gas
September 30, 2008
-Millions of Dollars-
	Quoted Prices in
	Active Markets		Significant Other			Significant
	for Identical		Observable			Unobservable
	Assets (Level 1)		Inputs (Level 2)			Inputs (Level 3)		Total
Investments⁽¹⁾	$	12	$	—		$	—	$	12
Energy Contracts⁽²⁾		—		(10	)		—		(10	)

Total	$	12	$	(10	)	$	—	$	2


(1)		Investments are based on observable market prices and comprise of the fair value of Commercial Paper and Money Market funds.

(2)		Energy contracts include gas swap agreements (Level 2) entered into to take advantage of favorable market conditions and reduce exposure to energy price risk. The amounts include current and non-current assets and are net of current and non-current liabilities.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity Outlook

UNS Gas’ capital requirements consist primarily of capital expenditures. In the first nine months of 2008, capital expenditures were $13 million. UNS Gas expects internal cash flows to fund its future operating activities and a large portion of its construction expenditures. If natural gas prices rise and UNS Gas is not allowed to recover its projected gas costs or PGA bank balance on a timely basis, UNS Gas may require additional funding to meet operating and capital requirements. Sources of funding future capital expenditures could include draws on the UNS Gas/UNS Electric Revolver, additional credit lines, the issuance of long-term debt, or capital contributions from UniSource Energy. The rate increase approved by the ACC in November 2007 covers some, but not all, of UNS Gas’ higher costs and capital investments. UNS Gas may need to rely more heavily on external funding sources for capital expenditures until it receives additional rate relief. See Outlook and Strategies, Economic Conditions and UniSource Energy, Liquidity and Capital Resources, Liquidity, Access to Revolving Credit Facilities, above for more information regarding the potential impact of current financial market conditions.

Operating Cash Flow and Capital Expenditures

The table below provides summary information for operating cash flow and capital expenditures for the first nine months of 2008 and 2007.


Nine Months Ended September 30,	2008		2007
	-Millions of Dollars-

Net Cash Flows — Operating Activities	$	8	$	19
Capital Expenditures		13		18

Operating cash flows decreased in 2008 due to a reduction in the over-recovered balance of PGA costs and the recording of $7 million of payments to affiliates as a reduction to operating cash flows (previously recorded as a reduction to financing cash flows).

UNS Gas/UNS Electric Revolver

The UNS Gas/UNS Electric Revolver is a $60 million unsecured revolving credit facility which matures in August 2011. Either borrower may borrow up to a maximum of $45 million so long as the combined amount borrowed does not exceed $60 million.

UNS Gas expects to draw upon the UNS Gas/UNS Electric Revolver from time to time for seasonal working capital purposes, to fund a portion of its capital expenditures, or to issue letters of credit to provide credit enhancement for its natural gas procurement and hedging activities. As of November 4, 2008, UNS Gas had a $10 million letter of credit outstanding and no outstanding borrowings under the UNS Gas/UNS Electric Revolver.

Interest Rate Risk

UNS Gas is subject to interest rate risk resulting from changes in interest rates on its borrowings under its revolving credit facility. The interest paid on revolving credit borrowings is variable. As a result of recent volatility in interest rates, UNS Gas may be required to higher rates of interest on borrowings under its revolving credit facility. See Item 3. Qualitative and Quantitative Disclosures about Market Risk, Credit Risk, below.

Senior Unsecured Notes

UNS Gas has $100 million of senior unsecured notes that are guaranteed by UES. The note purchase agreement for UNS Gas restricts transactions with affiliates, mergers, liens, restricted payments and incurrence of indebtedness, and also contains a minimum net worth test. As of September 30, 2008, UNS Gas was in compliance with the terms of its note purchase agreement.

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

Contractual Obligations

There have been no significant changes in UNS Gas’ contractual obligations or other commercial commitments from those reported in our 2007 Annual Report on Form 10-K, other than:

In 2008, UNS Gas entered into forward gas purchase agreements through August 2011. UNS Gas estimates its minimum payments for these forward purchases to be $11 million for the three months ended December 31, 2008, $17 million in 2009, $12 million in 2010, and $7 million in 2011.

Dividends on Common Stock

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

UNS ELECTRIC

RESULTS OF OPERATIONS

UNS Electric reported net income of $3 million in the third quarters of 2008 and 2007.

Similar to TEP, UNS Electric’s operations are generally seasonal in nature, with peak energy demand occurring in the summer months. The table below shows UNS Electric’s kWh sales and revenues for the third quarters of 2008 and 2007.


	Sales				Revenue
Three Months Ended September 30,	2008		2007		2008		2007
	-Millions of kWh-				-Millions of Dollars-
Electric Retail Sales:
Residential		300		314	$	35	$	31
Commercial		183		187		21		19
Industrial		58		54		6		4
Other		1		—		—		—

Total Electric Retail Sales		542		555	$	62	$	54
Electric Wholesale Sales		77		1		5		—

Total Electric Sales		619		556	$	67	$	54

Retail kWh sales decreased 2% in the third quarter of 2008 due to mild weather and a weakening local economy. Revenues were $8 million, or 15% higher due in part to a rate increase that was effective on June 1, 2008. See Factors Affecting Results of Operations, Rates and Regulation, General Rate Case Filing, below for more information.

Wholesale revenues increased by $5 million in the third quarter of 2008. Wholesale sales are made primarily from contract and resource capacity agreements that became effective June 1, 2008, subsequent to the expiration of the PWMT full requirements contract.

The table below provides summary financial information for UNS Electric.


Three Months Ended September 30,	2008		2007
	-Millions of Dollars-
Retail Electric Revenues	$	62	$	54
Wholesale Electric Revenues		5		—
Other Revenues		1		1

Total Operating Revenues		68		55

Purchased Energy Expense		46		37
Fuel Expense		4		—
Other Operations and Maintenance Expense		8		8
Depreciation and Amortization		3		3
Taxes other than Income Taxes		1		1

Total Other Operating Expenses		62		49

Operating Income		6		6

Other Income		—		—
Total Interest Expense		2		1
Income Tax Expense		1		2

Net Income	$	3	$	3

Nine Months Ended September 30, 2008 Compared with the Nine Months Ended September 30, 2007

UNS Electric reported net income of $4 million in the first nine months of 2008 and $5 million in the same period last year. Results in the first nine months of 2007 include a pre-tax gain of $1 million related to the sale of land.

The table below shows UNS Electric’s kWh sales and revenues for the first nine months of 2008 and 2007.


	Sales				Revenue
Nine Months Ended September 30,	2008		2007		2008		2007
	-Millions of kWh-				-Millions of Dollars-

Electric Retail Sales:
Residential		667		693	$	74	$	69
Commercial		485		482		53		49
Industrial		162		149		14		12
Other		2		2		—		—

Total Electric Retail Sales		1,316		1,326	$	141	$	130
Electric Wholesale Sales		104		2		8		—

Total Electric Sales		1,420		1,328	$	149	$	130

In the first nine months of 2008, retail kWh sales were impacted by mild weather and a weakening local economy, resulting in sales similar to those during the first nine months of 2007. An increase in commercial and industrial kWh sales and a rate increase that went into effect on June 1, 2008, contributed to the 8% increase in retail revenues in the first nine months of 2008 compared with the same period last year.

Wholesale revenues increased by $8 million in first nine months of 2008. Wholesale sales are made primarily from contract and resource capacity agreements that became effective June 1, 2008, subsequent to the expiration of the PWMT full requirements contract.

The table below provides summary financial information for UNS Electric.


Nine Months Ended September 30,	2008		2007
	-Millions of Dollars-
Electric Revenues	$	141	$	130
Wholesale Electric Revenues		8		—
Other Revenues		2		1

Total Operating Revenues		151		131

Purchased Energy Expense		100		87
Fuel Expense		5		—
Other Operations and Maintenance Expense		22		21
Depreciation and Amortization		10		10
Taxes other than Income Taxes		3		3

Total Other Operating Expenses		140		121


Operating Income		11		10

Other Income		—		2
Total Interest Expense		5		4
Income Tax Expense		2		3

Net Income	$	4	$	5

FACTORS AFFECTING RESULTS OF OPERATIONS

Rates and Regulation

General Rate Case Filing

In December 2006, UNS Electric filed a general rate case. In May 2008, the ACC issued an order which is summarized below.


Test year — 12 months ended June 30, 2006	Requested by UNS Electric	2008 ACC Order
Original cost rate base	$141 million	$131 million
Revenue deficiency	$8.5 million	$4 million
Total rate increase (over test year revenues)	5.5%	2.5%
Cost of long-term debt	8.2%	8.2%
Cost of equity	11.8%	10.0%
Actual capital structure	49% equity / 51% debt	49% equity / 51% debt
Weighted average cost of capital	9.9%	9.0%

Purchased Power and Fuel Adjustment Clause

As part of the May 2008 ACC order, a new PPFAC mechanism took effect on June 1, 2008. The PPFAC mechanism has a forward component and a true-up component. The forward component of the PPFAC rate is based on forecasted fuel and purchased power costs. The true-up component reconciles actual fuel and purchased power costs with the amounts collected in the prior year and any amounts under/over-collected will be collected/refunded from/to customers. The ACC approved a cap on the PPFAC rate of 1.73 cents per kWh, resulting in total fuel and purchased power recovery of approximately 8.7 cents per kWh, an increase of approximately 1.7 cents per kWh in UNS Electric’s average retail rate.

2009 General Rate Case Filing

UNS Electric expects to file a new rate case application with the ACC in 2009 to recover increasing capital and operating costs.

Line Extension Policy

As part of the May 2008 ACC order, UNS Electric is required to charge customers for the total cost of line extensions, eliminating UNS Electric’s prior practice of providing a portion of line extensions free of charge to its customers. UNS Electric filed an implementation plan with the ACC in June 2008. UNS Electric estimates the plan, which is subject to ACC approval, will become effective in the first quarter of 2009.

Purchased Power Agreement

As part of its rate case, UNS Electric requested that the ACC approve the transfer of the 90 MW BMGS from UED to UNS Electric and include the cost of the project in rate base effective June 1, 2008. The ACC denied UNS Electric’s requested treatment of BMGS. As a result, UED and UNS Electric have entered into a Power Purchase and Sales Agreement (PPA) pursuant under which UED sells all the output of BMGS to UNS Electric over a five-year term. The PPA is a tolling arrangement in which UNS Electric takes operational control of BMGS and assumes all risk of operation and maintenance costs, including fuel. Under the terms of the PPA, UNS Electric pays UED a capacity charge. The costs associated with the PPA are recoverable through UNS Electric’s PPFAC.

Renewable Energy Standard and Tariff

In April 2008, the ACC approved a REST plan for UNS Electric to be implemented starting on June 1, 2008. The plan is based on an ACC Staff recommendation that will result in approximately $3 million collected from customers annually to pay for REST compliance costs. The funds received from customers under the REST plan will be used to offset costs incurred by UNS Electric under the REST plan.

Fair Value Measurements

UNS Electric adopted FAS 157, Fair Value Measurements, on January 1, 2008 which, among other things, establishes a three-tier value hierarchy, based on the valuation techniques used to determine the fair value of derivative assets and liabilities. Where valuations are based on quoted prices in active markets these are categorized as Level 1. Where observable inputs are available for substantially the full terms of the asset or liability, the instrument is categorized under FAS 157 as Level 2 measurements. Derivatives that are primarily valued using an aggregate pricing service or published prices that represent a consensus reporting of multiple brokers are categorized in Level 3. In addition, complex or structured transactions can introduce the need for internally-developed model inputs that might not be observable in or corroborated by the market. When such inputs have a significant impact on the measurement of fair value, the instrument is categorized under FAS 157 as Level 3 measurements.

The following table sets forth, by level within the fair value hierarchy, UNS Electric’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of September 30, 2008. As required by FAS 157, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.


	UNS Electric
	September 30, 2008
	- Millions of Dollars -
	Quoted Prices in
	Active Markets		Significant Other			Significant
	for Identical		Observable			Unobservable
	Assets (Level 1)		Inputs (Level 2)			Inputs (Level 3)			Total
Investments⁽¹⁾	$	7	$	—			—		$	7
Energy Contracts⁽²⁾		—		(3	)	$	(10	)		(13	)

Total	$	7	$	(3	)	$	(10	)	$	(6	)


(1)		Investments are based on observable market prices and comprise of the fair value of Commercial Paper and Money Market funds.

(2)		Energy contracts include gas swap agreements (Level 2), forward power purchase contracts (Level 3), and forward power purchase contracts indexed to gas (Level 3), entered into to take advantage of favorable market conditions and reduce exposure to energy price risk. The amounts include current and non-current assets and are net of current and non-current liabilities.

UNS Electric recorded in the three and nine months ended September 30, 2008, unrealized losses of $45 million and $20 million, respectively, in net Regulatory Assets due to the change in the fair value of forward power purchase contracts classified as Level 3 in the fair value hierarchy. These changes in fair value were due to lower forward power prices on fixed price forward power purchases.

UNS Electric’s Level 3 derivatives include certain energy contracts where published prices are not readily available. These include contracts for delivery periods during non-standard time blocks, contracts for delivery during only a few months of a given year when prices are quoted only for the annual average, or contracts for delivery at illiquid delivery points. In these cases, UNS Electric applies certain management assumptions to value such contracts. These assumptions include applying historical price curve relationships to calendar year quotes, applying percentage multipliers to value non-standard time blocks, including a combination of market credit default swap data and historical recovery rates for subordinated bonds and including adjustments for transmission and line losses to value contracts at illiquid delivery points. UNS Electric reviews these assumptions on a quarterly basis.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity Outlook

In the first nine months of 2008, UNS Electric’s capital expenditures were $20 million. UNS Electric expects internal cash flows to fund a portion of its construction expenditures. Additional sources of funding future capital expenditures could include draws on the UNS Gas/UNS Electric Revolver, additional credit lines, the issuance of long-term debt, or capital contributions from UniSource Energy. In April 2007, UniSource Energy contributed $10 million of capital to UNS Electric. The rate increase approved by the ACC in May 2008 covers some, but not all, of UNS Electric’s higher costs and capital investments. See Outlook and Strategies, Economic Conditions and UniSource Energy, Liquidity and Capital Resources, Liquidity, Access to Revolving Credit Facilities, above for more information regarding the potential impact of current financial market conditions.

In August 2008, UNS Electric issued $100 million of unsecured debt. A portion of the proceeds was used to pay off $60 million of notes that matured on August 11, 2008. The remaining proceeds were used to repay outstanding borrowings by UNS Electric under the UNS Gas/UNS Electric Revolver and for general corporate purposes. See Senior Unsecured Notes, below.

Operating Cash Flow and Capital Expenditures

The table below provides summary information for operating cash flow and capital expenditures for the first nine months of 2008 and 2007.


Nine Months Ended September 30,	2008		2007
	- Millions of Dollars -
Net Cash Flows — Operating Activities	$	7	$	19
Capital Expenditures		20		31

Operating cash flows decreased in 2008 due to: the recording of $5 million of payments to affiliates as a reduction to operating cash flows (previously recorded as a reduction to financing cash flows); a $4 million decrease in cash receipts from retail and wholesale electric sales, less fuel and purchased energy costs, resulting from mild weather and weakening local economic conditions; and a $3 million increase in collateral payments to power trading counterparties.

UNS Gas/UNS Electric Revolver

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

UNS Electric expects to draw upon the UNS Gas/UNS Electric Revolver from time to time for seasonal working capital purposes and to fund a portion of its capital expenditures. As of November 4, 2008, UNS Electric had $8 million in outstanding borrowings and $12 million in letters of credit issued under the UNS Gas/UNS Electric Revolver.

Interest Rate Risk

UNS Electric is subject to interest rate risk resulting from changes in interest rates on its borrowings under its revolving credit facility. The interest paid on revolving credit borrowings is variable. As a result of recent volatility in interest rates, UNS Electric may be required to pay higher rates of interest on borrowings under its revolving credit facility. See Item 3. Qualitative and Quantitative Disclosures about Market Risk, Credit Risk, below.

Senior Unsecured Notes

On August 7, 2008, UNS Electric issued $50 million of 6.50% senior unsecured notes and $50 million of 7.10% senior unsecured notes due August 2015 and August 2023, respectively. The notes are guaranteed by UES. The note purchase agreement for UNS Electric contains certain restrictive covenants, including restrictions on transactions with affiliates, mergers, liens to secure indebtedness, restricted payments, and incurrence of indebtedness. As of September 30, 2008, UNS Electric was in compliance with the terms of its note purchase agreement.

UNS Electric used $60 million of the proceeds to repay the 7.61% senior unsecured notes that matured on August 11, 2008. On August 7, 2008, the remaining proceeds were used to repay UNS Electric’s outstanding borrowings under the UNS Gas/UNS Electric Revolver and for general corporate purposes.

Contractual Obligations

There have been no significant changes in UNS Electric’s contractual obligations or other commercial commitments from those reported in our 2007 Annual Report on Form 10-K, other than:.

•		In 2008, UNS Electric entered into forward gas purchase agreements through August 2011. UNS Electric estimates its minimum payments for these forward purchases to be less than $1 million for the three months ended December 31, 2008,, $6 million in 2009, $3 million in 2010, and less than $1 million in 2011.

•		In 2008, UNS Electric entered into forward power purchase agreements through 2010. Some of these contracts are indexed to natural gas prices. UNS Electric estimates it minimum payments under these contracts to be $22 million in 2009 and $11 million in 2010 based on natural gas prices at September 30, 2008.

Dividends on Common Stock

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

OTHER NON-REPORTABLE BUSINESS SEGMENTS

RESULTS OF OPERATIONS

The table below summarizes the income (loss) for the Other non-reportable segments.


Three Months Ended September 30,	2008			2007
	- Millions of Dollars -
UED	$	1		$	—
Millennium Investments		—			—
UniSource Energy Parent Company		(2	)		(2	)

Total Other	$	(1	)	$	(2	)


Nine Months Ended September 30,	2008			2007
	- Millions of Dollars -
UED	$	1		$	—
Millennium Investments		—			1
UniSource Energy Parent Company		(4	)		(4	)

Total Other	$	(3	)	$	(3	)

UniSource Energy Parent Company

UniSource Energy parent company expenses include interest expense (net of tax) related to the UniSource Energy Convertible Senior Notes and the UniSource Credit Agreement.

UED

Construction of the 90 MW BMGS in Kingman, Arizona was completed in May 2008. UED sells the output of BMGS to UNS Electric through a PPA. See UNS Electric, Factors Affecting Results of Operation, Purchased Power Agreement, above.

UED financed BMGS with borrowings from UniSource Energy under an inter-company note payable. At September 30, 2008, there was $59 million outstanding and interest is payable quarterly at LIBOR plus 1.25%. The completed cost of BMGS was $59 million.

FACTORS AFFECTING RESULTS OF OPERATIONS

Millennium Investments

In June 2008, Millennium recorded a pre-tax loss of $2 million due to an impairment of its investment in Valley Ventures. The book value of Valley Ventures as of September 30, 2008 was $3 million.

Nations Energy Corporation (Nations Energy), a wholly-owned subsidiary of Millennium, has been inactive since 2001. As of September 30, 2008, Nations Energy had a deferred tax asset of $3 million related to investment losses that have not been reflected on UniSource Energy’s consolidated income tax return.

Millennium is in the process of exiting its remaining investments. At September 30, 2008, Millennium’s investment balance was $30 million and had $4 million in cash.

The following table sets forth, by level within the fair value hierarchy, MEH’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of September 30, 2008. As required by FAS 157, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

September 30, 2008

- Millions of Dollars -

Quoted Prices in

Active Markets

Significant Other

Significant

for Identical

Observable

Unobservable

Assets (Level 1)

Inputs (Level 2)

Inputs (Level 3)

Total

Investments

—

LIQUIDITY AND CAPITAL RESOURCES

Millennium made a $21 million dividend payment to UniSource Energy in September 2008, $10 million in April 2007 and $5 million in February 2007.

Millennium currently owns 50% of Carboelectrica Sabinas, S. de R.L. de C.V. (Sabinas), a Mexican limited liability company. The book value of Sabinas as of September 30, 2008 was $14 million. Millennium is currently exploring different opportunities to monetize its interest in Sabinas.

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

CRITICAL ACCOUNTING ESTIMATES

In preparing financial statements under Generally Accepted Accounting Principles (GAAP), management exercises judgment in the selection and application of accounting principles, including making estimates and assumptions. UniSource Energy and TEP’s Critical Accounting Estimates are described in our Form 10-K for the year ended December 31, 2007 and includes the following:

	•		Accounting for Rate Regulation

	•		Accounting for Asset Retirement Obligations

	•		Pension and Other Postretirement Benefit Plan Assumptions

	•		Accounting for Derivative Instruments, Trading Activities and Hedging Activities

	•		Unbilled Revenue — TEP, UNS Gas and UNS Electric

	•		Plant Asset Depreciable Lives — TEP, UNS Gas and UNS Electric

	•		Deferred Tax Valuation

Each of our critical accounting estimates involves complex situations requiring a high degree of judgment either in the application and interpretation of existing literature or in the development of estimates that impact the financial statements. Except for incorporating counterparty credit risk, using a combination of market credit default swap data and historical recovery rates for subordinated bonds, when determining the fair value of derivative instruments, there have been no significant changes in our accounting policies from those disclosed in our Form 10-K for the year ended December 31, 2007. However, the 2008 proposed settlement of the TEP rate proceeding may result in TEP using cost-of service principles for its generation operations, thereby requiring TEP to reapply FAS 71.

NEW ACCOUNTING PRONOUNCEMENTS

The FASB recently issued the following Statements of Financial Accounting Standards (FAS):

	•		FAS 161, Disclosures About Derivative Instruments and Hedging Activities an amendment to FAS 133, Accounting for Derivative Instruments and Hedging Activities, issued March 2008, requires enhanced disclosures about an entity’s derivative and hedging activity. The standard requires that the objectives for using derivative instruments be disclosed in terms of underlying risk so that the reader understands the purpose of derivative use in terms of the risks that the entity is intending to manage. The standard also requires disclosure of the location in the financial statements of derivative balances as well as the location of gains and losses incurred during the reporting period. The standard will be applicable for fiscal years or interim periods beginning on or after November 15, 2008, with early adoption encouraged. The Company is currently assessing the impact of this statement.

	•		FAS 160, Accounting and Reporting of Noncontrolling Interests in Consolidated Financial Statements, issued December 2007, will change the accounting and reporting for minority interests, requiring such amounts to be classified as a component of equity, and will also change the accounting for transactions with minority-interest holders. The standard will be applicable for fiscal years beginning on or after December 15, 2008 on a prospective basis. Early adoption is prohibited and business combinations with acquisition dates prior to the effective date will not be adjusted upon application. We do not expect this pronouncement to have a material impact on our financial statements.

	•		FAS 141(R) Business Combinations - a replacement of FAS No. 141, issued December 2007, requires companies to record acquisitions at fair value. FAS 141(R) changes the definition of a business and a business combination and is generally expected to increase the number of transactions that will need to be accounted for at fair value. The standard will be applicable for fiscal years beginning on or after December 15, 2008 and generally on a prospective basis. Early adoption is prohibited and business combinations with acquisition dates prior to the effective date will not be adjusted upon application. We do not expect this pronouncement to have a material impact on our financial statements.

	•		FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active — issued October 2008, provides guidance clarifying how FAS 157 Fair Value Measures (FAS 157) should be applied in markets that are not active. The guidance reaffirms the notion of fair value as an exit price as of the measurement date. The FSP emphasizes that approaches other than the market value approach to determine fair value, such as the use of management’s internal assumptions about future cash flows and appropriately risk-adjusted discount rates, may be appropriate. The FSP, which is effective upon issuance and applicable to prior periods for which financial statements have not yet been issued, did not have a material impact on our financial statements.

SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS

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

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

1.		The resolution of pending retail rate case proceedings and the resulting rate structures.

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

3.		Demand conditions in our retail service areas, including economic conditions, weather conditions, rate structures, demographic patterns, competing energy alternatives and the status of retail competition.

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

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

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

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

8.		Changes in the depreciable lives of our assets.

9.		Unanticipated changes in future liabilities relating to employee benefit plans due to changes in market values of retirement plan assets and health care costs.

10.		The outcome of any ongoing or future litigation.

ITEM 3. — QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information contained in this Item updates, and should be read in conjunction with, information included in Part II, Item 7A in UniSource Energy and TEP’s Annual Report on Form 10-K for the year ended December 31, 2007, in addition to the interim condensed consolidated financial statements and accompanying notes presented in Items 1 and 2 of this Form 10-Q.

We are exposed to various forms of market risk. Changes in interest rates, returns on marketable securities, and changes in commodity prices may affect our future financial results. For additional information concerning risk factors, including market risks, see Safe Harbor for Forward-Looking Statements, above.

Risk Management Committee

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

Interest Rate Risk

TEP is exposed to interest rate risk resulting from changes in interest rates on certain of its variable rate debt obligations. At September 30, 2008 and December 31, 2007, TEP had $459 million and $329 million in tax-exempt variable rate debt outstanding, respectively. The increase in 2008 is due to the issuance of $130 million of 2008 Pima B Bonds in June 2008. The interest rates on TEP’s tax-exempt variable rate debt are reset weekly by its remarketing agents. The maximum interest rate payable under the indentures for these bonds is 10% on the 2008 Pima B Bonds and 20% on the other $329 million in IDBs. The average interest rate on TEP’s variable rate debt (excluding letter of credit fees) was 3.67% in 2007, and has ranged from 1.15% to 3.43% until mid- September 2008 when the short-term debt markets began to experience significant disruptions following the bankruptcy filing of Lehman Brothers Holdings, Inc. and the deterioration of creditworthiness of other large financial institutions. In mid-September 2008, TEP’s weekly interest rates on its tax-exempt variable rate debt reached as high as 8.09%. As of November 4, 2008 the average rate on this debt was 1.72%. Until confidence is restored in the short-term debt markets, TEP may be required to pay higher interest on its tax-exempt variable rate debt. A 100 basis point increase in average interest rates on this debt, over a twelve month period, would result in a decrease in TEP’s pre-tax net income of approximately $5 million.

UniSource Energy, TEP, UNS Gas and UNS Electric are also subject to interest rate risk resulting from changes in interest rates on their borrowings under revolving credit facilities. Revolving credit borrowings may be made on the basis of a spread over LIBOR or an Alternate Base Rate. With the recent disruptions in the financial markets, the spread between LIBOR and other similar maturity short-term rates, such as U.S. Treasury securities, has been significantly higher than historical relationships. For example, 30-day LIBOR increased from approximately 2.50% on September 15, 2008 to 4.36% on October 16, 2008. As a result, UniSource Energy, TEP, UNS Gas and UNS Electric may be required to pay significantly higher rates of interest on LIBOR borrowings under their revolving credit facilities.

Marketable Securities Risk

Commodity Price Risk

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

TEP

Purchases and Sales of Energy

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

TEP’s risk management policies also allow for financial purchases and sales of energy subject to specified risk parameters established and monitored by the Risk Management Committee. These include financial trades in a futures account on an exchange, with the intent of optimizing market opportunities.

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

As required by FAS 157, for the quarter ended September 30, 2008, TEP considered the impact of non-performance risk in the measurement of fair value of its derivative assets. TEP made an adjustment to reduce the fair value of its derivative assets by calculating the potential default probabilities (net of recoveries) for each of its counterparties with positive mark-to-market credit exposures. The total adjustments to TEP derivative asset fair value was less than $0.5 million.

To adjust the value of its derivative forward power sales and purchases, classified as cash flow hedges, to fair value in Other Comprehensive Income, TEP recorded the following net unrealized gains (losses):


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2008		2007		2008		2007
	-In Millions-				-In Millions-
Unrealized Gains (Loss)	$	5	$	1	$	2	$	—

TEP also reported the following net unrealized gains and losses on forward power sales and purchases in Wholesale Sales and Purchased Energy.


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2008		2007		2008			2007
	-In Millions-				-In Millions-
Unrealized Gain (Loss)	$	1	$	—	$	(2	)	$	—

Natural Gas

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

In the first nine months of 2008, the average market price of natural gas was $8.47 per MMBtu, or 38% higher than the same period in 2007. The table below summarizes TEP’s gas generation output and purchased power for the first nine months of 2008 and 2007.


Nine Months Ended September 30,	2008		2007		2008			2007
	-MWhs-				% of Total Resources
Gas-Fired Generation		722,000		841,000		6	%		8	%
Purchased Power		2,341,000		1,772,000		21	%		16	%

To adjust the value of its derivative gas swap contracts, classified as cash flow hedges, to fair value in Other Comprehensive Income, TEP recorded the following net unrealized gains (losses):


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008		2007
	-In Millions-						-In Millions-
Unrealized Gain (Loss)	$	(27	)	$	(3	)	$	—	$	(6	)

TEP also reported the following net unrealized gains and losses on forward gas swap contracts in fuel expense.


	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2008			2007		2008			2007
	-In Millions-					-In Millions-
Unrealized Gain (Loss)	$	(7	)	$	—	$	(3	)	$	—

The chart below displays the valuation methodologies and maturities of TEP’s power and gas derivative contracts.


	Unrealized Gain (Loss) of TEP’s
	Hedging and Trading Activities
	- Millions of Dollars -
									Total
	Maturity 0 — 6		Maturity 6 — 12			Maturity			Unrealized
Source of Fair Value At September 30, 2008	months		months			over 1 yr.			Gain (Loss)
Prices actively quoted	$	4	$	(4	)	$	(2	)	$	(2	)
Prices based on models and other valuation methods		—		(1	)		—			(1	)

Total	$	4	$	(5	)	$	(2	)	$	(3	)

Sensitivity Analysis of Derivatives

TEP uses sensitivity analysis to measure the impact of an unfavorable change in market prices on the fair value of its derivative forward contracts. Unrealized gains and losses related to TEP’s derivative contracts that are not cash flow hedges are reported on the income statement. Unrealized gains and losses related to derivative contracts that are cash flow hedges are reported in Other Comprehensive Income; the unrealized gains and losses are reversed as contracts settle and realized gains or losses are recorded. The chart below summarizes the change in unrealized gains or losses if market prices increase or decrease by 10%, as of September 30, 2008.


	- Millions of Dollars -
Change in Market Price As of September 30, 2008	10% Increase		10% Decrease
Non-Cash Flow Hedges
Forward power sales and purchase contracts	$	1	$	(1	)
Gas swap agreements		2		(2	)

Cash Flow Hedges
Forward power sales and purchase contracts	$	—	$	—
Gas swap agreements		3		(3	)

Coal

TEP is subject to commodity price risk from changes in the price of coal used to fuel its coal-fired generating plants. The commodity price risk from changes in the price of coal have not changed materially from the commodity price risks reported in our 2007 Annual Report on Form 10-K.

UNS Gas

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

To adjust the value of its gas swap agreements, classified as cash flow hedges, to fair value in Other Comprehensive Income, UNS Gas recorded unrealized losses for the nine months ended September 30, 2008 of $10 millions. In the nine months ended September 30, 2007, UNS Gas had no unrealized gains or losses recorded in OCI.

As required by FAS 157, for the quarter ended September 30, 2008, UNS Gas considered the impact of non-performance risk in the measurement of fair value of its derivative assets. No adjustment was required for UNS Gas as it had no derivative assets at September 30, 2008.

For UNS Gas’ forward gas purchase contracts, a 10% decrease in market prices would result in a decrease in unrealized net gains of $4 million reported in OCI, while a 10% increase in market prices would result in an increase in unrealized net gains reported of $4 million reported in OCI.

UNS Electric

UNS Electric’s fixed price full requirements supply agreement with PWMT expired in May 2008. Therefore, UNS Electric is exposed to commodity price risk from changes in the price for electricity and natural gas. This risk is mitigated through a PPFAC mechanism which fully recovers the costs incurred on a timely basis. As part of the May 2008 ACC order, a new PPFAC mechanism took effect on June 1, 2008. The PPFAC mechanism has a forward component and a true-up component. The forward component of the PPFAC rate is based on forecasted fuel and purchased power costs. The true-up component reconciles actual fuel and purchased power costs with the amounts collected in the prior year and any amounts under/over-collected will be collected from/refunded to customers. If the actual price of power is higher than the forecasted PPFAC rate, UNS Electric is exposed to the price difference until the subsequent 12-month period when the true-up component is adjusted to allow the recovery of this difference. The ACC approved a PPFAC rate of 1.73 cents per kWh, resulting in total fuel and purchased power recovery of approximately 8.7 cents per kWh, an increase of approximately 1.7 cents per kWh in UNS Electric’s average retail rate.

For the nine months ended September 30, 2008, UNS Electric recorded unrealized losses of $20 million to regulatory liabilities, to adjust the fair value of its forward power purchase derivative contracts. For the nine months ended September 30, 2007, UNS Electric recorded unrealized gains of $1 million to regulatory liabilities, to adjust the fair value of its forward power purchase derivative contracts.

For UNS Electric’s forward power purchase contracts, a 10% decrease in market prices would result in a decrease in unrealized net gains reported as a regulatory liability of $16 million, while a 10% increase in market prices would result in an increase in unrealized net gains reported as a regulatory liability of $16 million.

In 2007, UNS Electric began hedging a portion of its natural gas exposure from gas-indexed purchase power agreements that begin in September 2008 with fixed price contracts. In addition, UNS Electric began hedging a portion of its anticipated natural gas exposure from plant fuel for the period September 2008 and beyond. UNS Electric currently has approximately 40% of this aggregate summer exposure hedged for the summer of 2009. UNS Electric will obtain its remaining gas and purchased power needs through a combination of additional forward purchases and purchases in the short-term and spot markets.

For the nine months ended September 30, 2008 and 2007, UNS Electric recorded unrealized losses of $2 million and $1 million, respectively, to regulatory assets, to adjust the fair value of its gas swap agreements.

As required by FAS 157, for the quarter ended September 30, 2008, UNS Electric considered the impact of non-performance risk in the measurement of fair value of its derivative assets. No adjustment was required for UNS Electric as it had no derivative assets at September 30, 2008.

For UNS Electric’s forward gas purchase contracts, a 10% decrease in market prices would result in a decrease in unrealized net gains reported as a regulatory liability of $2 million, while a 10% increase in market prices would result in an increase in unrealized net gains reported as a regulatory liability of $2 million.

Credit Risk

UniSource Energy is exposed to credit risk in its energy-related marketing and trading activities related to potential nonperformance by counterparties. We manage the risk of counterparty default by performing financial credit reviews, setting limits, monitoring exposures, requiring collateral when needed, and using standard agreements which allow for the netting of current period exposures to and from a single counterparty. We calculate counterparty credit exposure by adding any outstanding receivable (net of amounts payable if a netting agreement exists) to the mark-to-market value of any forward contracts. A positive number means that we are exposed to the creditworthiness of our counterparties. If exposure exceeds credit limits or contractual collateral thresholds, we may request that a counterparty provide credit enhancement in the form of cash collateral or a letter of credit. Conversely, a negative exposure means that a counterparty is exposed to the creditworthiness of TEP, UNS Gas or UNS Electric. If such exposure exceeds credit limits or collateral thresholds, we may be required to post collateral in the form of cash or letters of credit.

During the last three years, financial institution counterparties have become active participants in the wholesale energy markets. TEP, UNS Electric and UNS Gas have each entered into short-term and long-term transactions with several financial institution counterparties with terms of one month through five years. Due to the recent turmoil in the financial and credit markets, we have been closely monitoring our transactions with financial institutions. As of September 30, 2008, the combined credit exposure to TEP, UNS Electric and UNS Gas from financial intuition counterparties was less than $1 million. In September 2008, a major financial institution filed for bankruptcy protection. TEP had less than $0.1 million in exposure to this counterparty in its accounts receivable, for which a reserve has been established.

As of September 30, 2008, TEP’s total credit exposure related to its wholesale marketing and gas hedging activities was approximately $31 million, including $5 million of inter-company exposure to UNS Electric. TEP had one non-investment grade counterparty with an exposure of greater than 10% of its total credit exposure, totaling approximately $19 million. This exposure results from a forward energy sale and related receivable from this counterparty that extends through December 2008.

TEP maintains a margin account with a broker to support certain risk management and trading activities. At September 30, 2008, TEP had less than $1 million in that margin account. At September 30, 2008, TEP had no credit enhancements posted with counterparties, and did not hold any collateral from its counterparties.

UNS Gas is subject to credit risk from non-performance by its supply and hedging counterparties to the extent that these contracts have a mark-to-market value in favor of UNS Gas. As of September 30, 2008, UNS Gas had purchased under fixed price contracts approximately 55% of the expected monthly consumption for the 2008/2009 winter season (November through March) and approximately 30% of its expected consumption for the 2009/2010 winter season. At September 30, 2008, UNS Gas had no mark-to-market credit exposure under its supply and hedging contracts. As of September 30, 2008, UNS Gas had no outstanding credit enhancements posted with counterparties, nor did UNS Gas hold any collateral from counterparties.

UNS Electric has entered into several energy purchase agreements to replace the full requirements contract it had with PWMT that expired May 31, 2008, as well as gas hedging contracts to hedge the risk in its gas-indexed power purchase agreements. To the extent that such contracts have a positive mark-to-market value, UNS Electric is exposed to credit risk under those contracts. At September 30, 2008, UNS Electric had no credit exposure under such contracts. As of September 30, 2008, UNS Electric had posted $12 million in letters of credit and and $2 million in cash collateral as credit enhancements with its counterparties and had not collected any collateral margin from its counterparties.

ITEM 4. — CONTROLS AND PROCEDURES

UniSource Energy and TEP’s Chief Executive Officer and Chief Financial Officer supervised and participated in UniSource Energy and TEP’s evaluation of their disclosure controls and procedures as such term is defined under Rule 13a — 15(e) or Rule 15d — 15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act), as of September 30, 2008. Disclosure controls and procedures are controls and procedures designed to ensure that information required to be disclosed in UniSource Energy and TEP’s periodic reports filed or submitted under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. These disclosure controls and procedures are also designed to ensure that information required to be disclosed by UniSource Energy and TEP in the reports that they file or submit under the Exchange Act is accumulated and communicated to management, including the principal executive and principal financial officers, or person performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Based upon the evaluation performed, UniSource Energy and TEP’s Chief Executive Officer and Chief Financial Officer concluded that UniSource Energy and TEP’s disclosure controls and procedures are effective.

While UniSource Energy and TEP continually strive to improve their disclosure controls and procedures to enhance the quality of their financial reporting, there has been no change in UniSource Energy or TEP’s internal control over financial reporting during the third quarter of 2008 that has materially affected, or is reasonably likely to materially affect, UniSource Energy or TEP’s internal control over financial reporting.

PART II — OTHER INFORMATION

ITEM 1. — LEGAL PROCEEDINGS

There are no pending material legal proceedings to which the Company is a party, other than routine litigation incidental to the business of the Company. We discuss other legal proceedings in Note 7 of Notes to Consolidated Financial Statements, Commitments and Contingencies.

ITEM 1A. — RISK FACTORS

The business and financial results of UniSource Energy and TEP are subject to numerous risks and uncertainties. The risks and uncertainties have not changed materially from those reported in our 2007 Annual Report on Form 10-K, other than:

Constricted credit markets may limit the ability of UniSource Energy, TEP, UNS Gas and UNS Electric to receive funding under their respective revolving credit facilities when required which could negatively impact liquidity.

UniSource Energy, TEP, UNS Gas and UNS Electric could experience difficulties in obtaining funding under their respective revolving credit facilities when required if lenders in the bank group file bankruptcy or refuse to fund when requested. If sufficient liquidity is not available to meet short-term working capital needs, UniSource Energy, TEP, UNS Gas and UNS Electric’s results of operations, net income and cash flows could be negatively impacted.

TEP, UNS Gas and UNS Electric may be required to post margin under their power and fuel supply agreements which could negatively impact their liquidity.

TEP, UNS Gas and UNS Electric secure power and fuel supply resources to serve their respective retail customers. The agreements under which TEP, UNS Gas and UNS Electric contracts for such resources include requirements to post credit enhancement in the form of cash or letters of credit under certain circumstances, including changes in market prices which affect contract values, or a change in creditworthiness the respective companies.

In order to post such credit enhancement, TEP, UNS Gas and UNS Electric would have to use available cash, draw under their revolving credit agreements, or issue letters of credit under their revolving credit agreements.

The maximum amount TEP may use under its revolving credit facility is $150 million. As of November 4, 2008, TEP had $139 million available to borrow under its revolving credit facility. The maximum amount UNS Gas or UNS Electric may use under their revolving credit facility is $45 million, so long as the combined amount does not exceed $60 million. As of November 4, 2008, UNS Gas and UNS Electric had $35 million and $20 million, respective to borrow under their revolving credit facility. If TEP, UNS Gas or UNS Electric were required to use their respective revolving credit facilities to post collateral, it may negatively impact TEP, UNS Gas and/or UNS Electric’s ability to fund their capital requirements.

ITEM 2. — UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS

Issuer Purchases of Equity Securities — None.

ITEM 5. — OTHER INFORMATION

NON-GAAP MEASURES

Adjusted EBITDA

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

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

Adjusted EBITDA and Net Cash Flows — Operating Activities


	UniSource Energy
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
	- Millions of Dollars -
Adjusted EBITDA (non-GAAP)	$	55		$	138		$	221		$	341
Net Cash Flows — Operating Activities (GAAP)		47			84			187			204
Net Cash Flows — Investing Activities (GAAP)		(55	)		(47	)		(359	)		(153	)
Net Cash Flows — Financing Activities (GAAP)	$	(25	)	$	(74	)	$	152		$	(95	)


	TEP
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
	- Millions of Dollars -
Adjusted EBITDA (non-GAAP)	$	40		$	126		$	178		$	303
Net Cash Flows — Operating Activities (GAAP)		55			70			187			163
Net Cash Flows — Investing Activities (GAAP)		(42	)		(25	)		(313	)		(97	)
Net Cash Flows — Financing Activities (GAAP)	$	(23	)	$	(77	)	$	133		$	(75	)

Reconciliation of Adjusted EBITDA to Cash Flows from Operations


	UniSource Energy
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
	- Millions of Dollars -
Adjusted EBITDA (non-GAAP) ⁽¹⁾	$	55		$	138		$	221		$	341
Amounts from the Income Statements:
Less: Income Taxes		(4	)		16			(1	)		28
Less: Total Interest Expense		31			34			93			103
Changes in Assets and Liabilities and Other Non-Cash Items		19			(4	)		58			(6	)

Net Cash Flows — Operating Activities (GAAP)		47			84			187			204

Net Cash Flows — Investing Activities (GAAP)		(55	)		(47	)		(359	)		(153	)

Net Cash Flows — Financing Activities (GAAP)		(25	)		(74	)		152			(95	)

Net Increase (Decrease) in Cash and Cash Equivalents (GAAP)	$	(33	)	$	(37	)	$	(20	)	$	(44	)


	TEP
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
	- Millions of Dollars -
Adjusted EBITDA (non-GAAP) ⁽¹⁾	$	40		$	126		$	178		$	303
Amounts from the Income Statements:
Less: Income Taxes		(5	)		16			(5	)		25
Less: Total Interest Expense		25			28			77			87
Changes in Assets and Liabilities and Other Non-Cash Items		35			(12	)		81			(28	)

Net Cash Flows — Operating Activities (GAAP)		55			70			187			163

Net Cash Flows — Investing Activities (GAAP)		(42	)		(25	)		(313	)		(97	)

Net Cash Flows — Financing Activities (GAAP)		(23	)		(76	)		133			(75	)

Net Increase (Decrease) in Cash and Cash Equivalents (GAAP)	$	(10	)	$	(31	)	$	7		$	(9	)


⁽¹⁾		Adjusted EBITDA was calculated as follows:


	UniSource Energy
	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2008			2007		2008			2007
	- Millions of Dollars -
Net Income (GAAP)	$	(11	)	$	25	$	(9	)	$	42
Amounts from the Income Statements:
Plus: Income Taxes		(4	)		16		(1	)		28
Total Interest Expense		31			34		93			103
Depreciation and Amortization		37			35		109			103
Amortization of Transition Recovery Asset		—			26		24			60
Depreciation included in Fuel and Other O&M Expense (see Note 13 of Notes to Consolidated Financial Statements)		2			2		5			5

Adjusted EBITDA (non-GAAP)	$	55		$	138	$	221		$	341


	TEP
	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2008			2007		2008			2007
	- Millions of Dollars -
Net Income (GAAP)	$	(12	)	$	26	$	(15	)	$	39
Amounts from the Income Statements:
Plus: Income Taxes		(5	)		16		(5	)		25
Total Interest Expense		25			28		77			87
Depreciation and Amortization		31			29		93			88
Amortization of Transition Recovery Asset		—			26		24			60
Depreciation included in Fuel and Other O&M Expense (see Note 13 of Notes to Consolidated Financial Statements)		1			1		4			4

Adjusted EBITDA (non-GAAP)	$	40		$	126	$	178		$	303

Net Debt and Total Debt and Capital Lease Obligations — TEP

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


	As of		As of
	September 30,		December
	2008		31, 2007
	- Millions of Dollars -
Net Debt (non-GAAP)	$	1,354	$	1,306
Total Debt and Capital Lease Obligations (GAAP)	$	1,433	$	1,411

Reconciliation of Total Debt and Capital Lease Obligations to Net Debt


	As of			As of
	September 30,			December
	2008			31, 2007
	- Millions of Dollars -
Total Debt (GAAP)	$	904		$	821

Capital Lease Obligations		511			531
Current Portion — Capital Lease Obligations		18			59

Total Debt and Capital Lease Obligations (GAAP)		1,433			1,411


Investment in Lease Debt		(79	)		(105	)

Net Debt (non-GAAP)	$	1,354		$	1,306

Ratio of Earnings to Fixed Charges

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


	9 Months Ended		12 Months Ended
	September 30, 2008		September 30, 2008
UniSource Energy		0.90		1.14

TEP		0.73		1.03

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 on indebtedness.

For the nine months ended September 30, 2008, UniSource Energy and TEP’s ratio of earnings to fixed charges less than 1.00. UniSource Energy and TEP’s earnings (as defined above) were deficient by $10 million and $22 million, respectively. The deficiencies are a result of: a provision for revenue subject to refund at TEP, partially offset by a decrease in TRA amortization; higher coal-related fuel expense at TEP; higher purchased power costs at TEP due partially to plant outages in the first and third quarters of 2008; lower retail sales at TEP due to mild weather and a weakening local economy; and a decrease in gains on the sale of SO2 emissions allowances.

ITEM 6. — EXHIBITS

See Exhibit Index.


Definitions			iv
— PART I —

Reports of Independent Registered Public Accounting Firm			1

Item 1. — Financial Statements			3

UniSource Energy Corporation

Comparative Condensed Consolidated Statements of Income			3

Comparative Condensed Consolidated Statements of Cash Flows			4

Comparative Condensed Consolidated Balance Sheets			5

Condensed Consolidated Statement of Changes in Stockholders’ Equity and Comprehensive Income			7

Tucson Electric Power Company

Comparative Condensed Consolidated Statements of Income			8

Comparative Condensed Consolidated Statements of Cash Flows			9

Comparative Condensed Consolidated Balance Sheets			10

Condensed Consolidated Statement of Changes in Stockholder’s Equity and Comprehensive Income			12

Notes to Condensed Consolidated Financial Statements			13

Note 1. Nature of Operations and Basis of Accounting Presentation			13

Note 2. Regulatory Matters			14

Note 3. Debt and Credit Facilities			17

Note 4. Business Segments			20

Note 5. Accounting for Derivative Instruments and Trading Activities			22

Note 6. Income Tax Matters			27

Note 7. Commitments and Contingencies			28

Note 8. Employee Benefits Plans			31

Note 9. Share-Based Compensation Plans			33

Note 10. Fair Value Measurements			35

Note 11. UniSource Energy Earnings Per Share (EPS)			39

Note 12. New Accounting Pronouncements			40

Note 13. Supplemental Cash Flow Information			41

Note 14. Review by Independent Registered Public Accounting Firm			42

Item 2. — Management’s Discussion and Analysis of Financial Condition and Results of Operations			43

UniSource Energy Consolidated			43

Overview of Consolidated Business			43

Outlook and Strategies			43

Results of Operations			45

Contribution by Business Segment			45

Liquidity and Capital Resources			46

Tucson Electric Power Company			51

Results of Operations			51

Factors Affecting Results of Operations			56

Liquidity and Capital Resources			61

UNS Gas			66

Results of Operations			66

Factors Affecting Results of Operations			68

Liquidity and Capital Resources			69

UNS Electric			71

Results of Operations			71

Factors Affecting Results of Operations			73

Liquidity and Capital Resources			74

Other Non-Reportable Business Segments			76

Results of Operations			76

Critical Accounting Estimates			77
Exhibit 12(a)
Exhibit 12(b)
Exhibit 15
Exhibit 31(a)
Exhibit 31(b)
Exhibit 31(c)
Exhibit 31(d)
Exhibit 32


New Accounting Pronouncements			78

Safe Harbor for Forward-Looking Statements			78

Item 3. — Quantitative and Qualitative Disclosures about Market Risk			79

Item 4. — Controls and Procedures			84

PART II – OTHER INFORMATION

Item 1. — Legal Proceedings			85

Item 1A. — Risk Factors			85

Item 2. — Unregistered Sale of Equity Securities and Use of Proceeds			85

Item 5. — Other Information			86

Non-GAAP Measures			86

Ratio of Earnings to Fixed Charges			88

Item 6. Exhibits			88

Signatures			89

Exhibit Index			90


	UNISOURCE ENERGY CORPORATION (Registrant)
Date: November 7, 2008	/s/ Kevin P. Larson
	Kevin P. Larson
	Senior Vice President and Principal Financial Officer

	TUCSON ELECTRIC POWER COMPANY (Registrant)
Date: November 7, 2008	/s/ Kevin P. Larson
	Kevin P. Larson
	Senior Vice President and Principal Financial Officer


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

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

15	—	Letter regarding unaudited interim financial information.

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

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

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

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

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


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