- -------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
OR
[ ] 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
Securities registered pursuant to Section 12(b) of the Act:
Name of Each Exchange
Registrant Title of Each Class on Which Registered
- ---------- ------------------- -------------------
UniSource Energy Common Stock, no par value and New York Stock Exchange
Corporation Preferred Share Purchase Rights Pacific Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether each registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes _X No __
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of each registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act).
UniSource Energy Corporation Yes X No
---- ---
Tucson Electric Power Company Yes No X
---- ----
The aggregate market value of UniSource Energy Corporation voting
Common Stock held by non-affiliates of the registrant was $630,807,609 based on
the last reported sale price thereof on the consolidated tape on June 30, 2003.
At March 10, 2004, 34,029,653 shares of UniSource Energy Corporation
Common Stock, no par value (the only class of Common Stock), were outstanding.
At March 10, 2004, 32,139,555 shares of Tucson Electric Power Company's
common stock, no par value, were outstanding, of which 32,139,434 shares were
held by UniSource Energy Corporation.
Documents incorporated by reference: Specified portions of UniSource
Energy Corporation's Proxy Statement relating to the 2004 Annual Meeting of
Shareholders are incorporated by reference into PART III.
- -------------------------------------------------------------------------------
This combined Form 10-K is separately filed by UniSource Energy Corporation and
Tucson Electric Power Company. Information contained in this document relating
to Tucson Electric Power Company is filed by UniSource Energy Corporation and
separately by Tucson Electric Power Company on its own behalf. Tucson Electric
Power Company makes no representation as to information relating to UniSource
Energy Corporation or its subsidiaries, except as it may relate to Tucson
Electric Power Company.
Table of Contents
Definitions v
-- PART I --
Item 1. - Business 1
Overview of Consolidated Business 1
TEP Electric Utility Operations 3
Service Area and Customers 4
Generating and Other Resources 6
Fuel Supply 8
Water Supply 10
Transmission Access 11
Rates and Regulation 12
TEP's Utility Operating Statistics 15
Environmental Matters 16
UniSource Energy Services 17
UNS Electric 17
Service Territory and Customers 17
Power Supply and Transmission 17
Rates and Regulation 17
UNS Gas 18
Service Territory and Customers 18
Gas Supply and Transmission 18
Rates and Regulation 19
Millennium Energy Holdings 19
UniSource Energy Development Company 21
Employees 21
SEC Reports available on UniSource Energy's Website 22
Item 2. - Properties 23
TEP Properties 23
UES Properties 24
Item 3. - Legal Proceedings 24
Item 4. - Submission of Matters to a Vote of Security Holders 25
-- Part II --
Item 5. - Market for Registrant's Common Equity and Related Stockholder
Matters 26
Item 6. - Selected Consolidated Financial Data 27
UniSource Energy 27
TEP 28
Non-GAAP Financial Measures 29
Item 7. - Management's Discussion and Analysis of Financial Condition and
Results of Operations 32
K-ii
Outlook and Strategies 32
UniSource Energy Consolidated 32
Results of Operations 33
Contribution by Business Segment 34
Liquidity and Capital Resources 35
Tucson Electric Power Company 39
Results of Operations 39
Factors Affecting Results of Operations 42
Liquidity and Capital Resources 44
UniSource Energy Services 50
Results of Operations 50
Factors Affecting Results of Operations 51
Liquidity and Capital Resources 52
Millennium Energy Holdings, Inc. 54
Results of Operations 54
UniSource Energy Development Company 56
Results of Operations 56
Springerville Generating Station Expansion 56
Critical Accounting Policies 56
New Accounting Pronouncements 63
Safe Harbor for Forward-Looking Statements 64
Item 7A. - Quantitative and Qualitative Disclosures about Market Risk 65
Item 8. - Consolidated Financial Statements and Supplementary Data 68
Report of Independent Auditors 69
UniSource Energy Corporation
Consolidated Statements of Income 70
Consolidated Statements of Cash Flows 71
Consolidated Balance Sheets 72
Consolidated Statements of Capitalization 73
Consolidated Statements of Changes in Stockholders' Equity 74
Tucson Electric Power Company
Consolidated Statements of Income 75
Consolidated Statements of Cash Flows 76
Consolidated Balance Sheets 77
Consolidated Statements of Capitalization 78
Consolidated Statements of Changes in Stockholders' Equity 79
Notes to Consolidated Financial Statements
Note 1. Nature of Operations and Summary of Significant
Accounting Policies 80
Note 2. Proposed Acquisition of UniSource Energy 88
Note 3. Establishment of UES 88
Note 4. TEP Regulatory Matters 91
Note 5. Accounting Change: Accounting for Asset Retirement
Obligations 94
Note 6. Segment and Related Information 96
Note 7. Accounting for Derivative Instruments, Trading
Activities and Hedging Activities 98
Note 8. Millennium 99
Note 9. Utility Plant and Jointly-Owned Facilities 101
Note 10. Debt and Capital Lease Obligations 103
Note 11. Fair Value of Financial Instruments 106
Note 12. Stockholders' Equity 107
Note 13. TEP Wholesale Accounts Receivable and Allowances 108
Note 14. Springerville Expansion 109
K-iii
Note 15. Commitments and Contingencies 109
Note 16. Income and Other Taxes 115
Note 17. Employee Benefit Plans 118
Note 18. Stock-Based Compensation Plans 122
Note 19. UniSource Energy Earnings Per Share 123
Note 20. Supplemental Cash Flow Information 125
Note 21. Quarterly Financial Data (Unaudited) 127
Schedule II - Valuation and Qualifying Accounts 130
Item 9 - Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure 131
Item 9A - Controls and Procedures 131
-- Part III --
Item 10 - Directors and Executive Officers of the Registrants 131
Item 11 - Executive Compensation 134
Item 12 - Security Ownership of Certain Beneficial Owners and Management 134
Item 13 - Certain Relationships and Related Transactions 134
Item 14 - Principal Accountant Fees and Services 134
-- Part IV --
Item 15 - Exhibits, Financial Statement Schedules, and Reports of Form 8-K 135
Signatures 137
Exhibit Index 141
K-iv
DEFINITIONS
The abbreviations and acronyms used in the 2003 Form 10-K are defined below:
- --------------------------------------------------------------------------------
ACC.............................. Arizona Corporation Commission.
ACC Holding Company Order........ The order approved by the ACC in November
1997 allowing TEP to form a holding
company.
AHMSA............................ Altos Hornos de Mexico, S.A. de C.V.
AHMSA owns 50% of Sabinas.
AMT.............................. Alternative Minimum Tax.
APS.............................. Arizona Public Service Company.
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.
CISO............................. California Independent System Operator.
Citizens......................... Citizens Communications Company.
Citizens Settlement Agreement An agreement with the ACC Staff dated
April 1, 2003, addressing rate case and
financing issues in the acquisition by
UniSource Energy of the Citizens'
Arizona gas and electric assets.
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 low daily temperatures.
CPX.............................. California Power Exchange.
Credit Agreement................. Credit Agreement between TEP and a
syndicate of banks, dated as of November
14, 2002.
Emissions 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.
EPA.............................. The Environmental Protection Agency.
ESP.............................. Energy Service Provider.
Express Line..................... 345-kV circuit connecting Springerville
Unit 2 to the Tucson 138-kV system.
FAS 71........................... Statement of Financial Accounting
Standards No. 71: Accounting for the
Effects of Certain Types of Regulation.
FAS 132.......................... Statement of Financial Accounting
Standards No. 132: Employers'
Disclosures about Pensions and
Other Postretirement Benefits.
FAS 133.......................... Statement of Financial Accounting
Standards No. 133: Accounting for
Derivative Instruments and Hedging
Activities.
FAS 143.......................... Statement of Financial Accounting
Standards No. 143: Accounting for Asset
Retirement Obligations.
FAS 149.......................... Statement of Financial Accounting
Standards No. 149: Amendment of
Statement 133 on Derivative Instruments
and Hedging Activities.
FERC............................. Federal Energy Regulatory Commission.
First Collateral Trust Bonds..... Bonds issued under the Indenture of Trust,
dated as of August 1, 1998, of TEP to
the Bank of New York, successor trustee.
First Mortgage Bonds............. First mortgage bonds issued under the
Indenture, dated as of April 1, 1941, of
TEP to JPMorgan Chase Bank, successor
trustee, as supplemented and amended.
Four Corners..................... Four Corners Generating Station.
GAAP............................. Generally Accepted Accounting Principles.
Global Solar..................... Global Solar Energy, Inc., a company that
develops and manufactures thin-film
photovoltaic cells. Millennium owns 99%
of Global Solar.
IDBs............................. Industrial development revenue or
pollution control revenue bonds.
IPS.............................. Infinite Power Solutions, Inc., a company
that develops thin-film batteries.
Millennium owns 72% of IPS.
K-v
IRS.............................. Internal Revenue Service.
ISO.............................. Independent System Operator.
ITN.............................. ITN Energy Systems, Inc. was formed to
provide research, development, and other
services. Millennium exchanged its
ownership of ITN for increased ownership
of Global Solar and currently owns no
interest in ITN.
ITC.............................. Investment tax credit.
kWh.............................. Kilowatt-hour(s).
kV............................... Kilovolt(s).
LOC.............................. Letter of Credit.
MEG.............................. Millennium Environmental Group, Inc., a
wholly-owned subsidiary of Millennium,
which manages and trades emission
allowances, coal, and related financial
instruments.
MicroSat......................... MicroSat Systems, Inc. is a company formed
to develop and commercialize small-scale
satellites. Millennium currently owns
35%.
Millennium....................... Millennium Energy Holdings, Inc., a
wholly-owned subsidiary of UniSource
Energy.
Mimosa........................... Minerales de Monclova, S.A. de C.V., an
owner of coal and associated gas
reserves and a supplier of metallurgical
coal to the steel industry and thermal
coal to the Mexican electricity
commission. Sabinas owns 19.5% of
Mimosa.
MMBtus........................... Million British Thermal Units.
MW............................... Megawatt(s).
MWh.............................. Megawatt-hour(s).
Navajo........................... Navajo Generating Station.
NOL.............................. Net Operating Loss carryback or
carryforward for income tax purposes.
PGA.............................. Purchased Gas Adjuster, a retail rate
mechanism designed to recover the cost
of gas purchased for retail gas
customers.
PNM.............................. Public Service Company of New Mexico.
Powertrusion..................... POWERTRUSION International, Inc., a
company owned 77% by Millennium, which
manufactures lightweight utility poles.
PPFAC............................ Purchase Power and Fuel Adjustor Clause.
PWCC............................. Pinnacle West Capital Corporation.
Revolving Credit Facility........ $60 million revolving credit facility
entered into under the Credit Agreement
between a syndicate of banks and TEP.
RTO.............................. Regional Transmission Organization.
Rules............................ Retail Electric Competition Rules.
Sabinas.......................... Carboelectrica Sabinas, S. de R.L.de C.V.,
a Mexican limited liability company.
Millennium owns 50% of Sabinas.
Saguaro Utility.................. An Arizona limited partnership, whose
general partner is Sage Mountain,
L.L.C. and whose limited partners
include investment funds affiliated with
Kohlberg Kravis Roberts & Co., L.P.,
J.P. Morgan Partners, L.L.C. and
Wachovia Capital Partners.
San Carlos....................... San Carlos Resources Inc., a wholly-owned
subsidiary of TEP.
San Juan......................... San Juan Generating Station.
Second Mortgage Bonds............ TEP's second mortgage bonds issued under
the Indenture of Mortgage and Deed of
Trust, dated as of December 1, 1992, of
TEP to the Bank of New York, successor
trustee, as supplemented.
SCE.............................. Southern California Edison Company.
SES.............................. Southwest Energy Solutions, Inc., a
wholly-owned subsidiary of Millennium.
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
K-vi
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 Lease....... 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.
SRP.............................. Salt River Project Agricultural
Improvement and Power District.
Sundt Generating Station......... H. Wilson Sundt Generating Station
(formerly known as the Irvington
Generating Station).
Sundt Lease...................... The leveraged lease arrangement relating
to Sundt Unit 4.
TEP.............................. Tucson Electric Power Company, the
principal subsidiary of UniSource
Energy.
TEP Settlement Agreement......... TEP's Settlement Agreement approved by the
ACC in November 1999 that provided for
electric retail competition and
transition asset recovery.
Therm............................ A unit of heating value equivalent to
100,000 British thermal units (Btu).
Tri-State........................ Tri-State Generation and Transmission
Association.
TruePricing...................... TruePricing, Inc., a start-up company
established to market energy related
products.
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.
UniSource Energy................. UniSource Energy Corporation.
UNS Electric..................... UNS Electric, Inc., a wholly-owned
subsidiary of UES, which acquired the
Citizens Arizona electric utility
assets.
UNS Gas.......................... UNS Gas, Inc., a wholly-owned subsidiary
of UES, which acquired the Citizens
Arizona gas utility assets.
WestConnect...................... The proposed for-profit RTO in which TEP
is a participant.
K-vii
PART I
This Annual Report on Form 10-K contains forward-looking statements as
defined by the Private Securities Litigation Reform Act of 1995. You should read
forward-looking statements together with the cautionary statements and important
factors included in this Form 10-K. (See Item 7. - Management's Discussion and
Analysis of Financial Condition and Results of Operations, Safe Harbor for
Forward-Looking Statements.) Forward-looking statements include statements
concerning plans, objectives, goals, strategies, future events or performance
and underlying assumptions. Forward-looking statements 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. 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.
ITEM 1. -- BUSINESS
- --------------------------------------------------------------------------------
OVERVIEW OF CONSOLIDATED BUSINESS
UniSource Energy Corporation (UniSource Energy) is a holding company
that owns substantially all of the outstanding common stock of Tucson Electric
Power Company (TEP), and all of the outstanding common stock of UniSource Energy
Services, Inc. (UES), Millennium Energy Holdings, Inc. (Millennium), and
UniSource Energy Development Company (UED).
TEP, an electric utility, has provided electric service to the
community of Tucson, Arizona, for over 100 years. UES, through its two operating
subsidiaries, provides gas and electric service to 30 communities in northern
and southern Arizona. Millennium invests in unregulated businesses, including a
developer of thin-film batteries and a developer and manufacturer of thin-film
photovoltaic cells. UED engages in developing generating resources and other
project development activities, including facilitating the expansion of the
Springerville Generating Station. We conduct our business in these four primary
business segments -- TEP's Electric Utility Segment, UES' Gas and Electric
Utility Segment, the Millennium Businesses Segment, and the UED Segment.
UniSource Energy was incorporated in the State of Arizona on March 8,
1995 and obtained regulatory approval to form a holding company in November
1997. On January 1, 1998, TEP and UniSource Energy exchanged shares of stock
resulting in TEP becoming a subsidiary of UniSource Energy. Following the share
exchange, TEP transferred the stock of its subsidiary Millennium to UniSource
Energy. See Note 1 of Notes to Consolidated Financial Statements--Nature of
Operations and Summary of Significant Accounting Policies.
ESTABLISHMENT OF UES
On August 11, 2003, UniSource Energy completed the purchase of the
Arizona gas and electric system assets from Citizens Communications Company
(Citizens) for a total of $223 million, comprised of the base purchase price
plus other operating capital adjustments and transaction costs. UniSource Energy
formed two new operating companies called UNS Electric, Inc. (UNS Electric) and
UNS Gas, Inc. (UNS Gas) to acquire these assets, as well as UES, an intermediate
holding company that holds the common stock of the operating companies.
AGREEMENT AND PLAN OF MERGER
On November 21, 2003, UniSource Energy and Saguaro Acquisition Corp., a
Delaware corporation, entered into an acquisition agreement providing for the
acquisition of all of the common stock of UniSource Energy for $25.25 per share
by an affiliate of Saguaro Utility Group L.P., an Arizona limited partnership
(Saguaro Utility), whose general partner is Sage Mountain, L.L.C. and whose
limited partners include investment funds affiliated with Kohlberg Kravis
Roberts & Co., L.P., J.P. Morgan Partners, LLC and Wachovia Capital Partners.
Frederick B. Rentschler is the managing member of Sage Mountain,
L.L.C., an Arizona limited liability company, and Saguaro Acquisition Corp. is a
wholly-owned indirect subsidiary of Saguaro Utility.
K-1
Pursuant to the terms of the acquisition agreement, Saguaro Acquisition
Corp. will merge with and into UniSource Energy. UniSource Energy will be the
surviving corporation, but will become an indirect wholly-owned subsidiary of
Saguaro Utility. Trading in our common stock on the New York Stock Exchange and
the Pacific Exchange will cease immediately as of the effective time of the
acquisition. After that time, the surviving corporation will delist our shares
from the New York Stock Exchange and the Pacific Exchange and de-register our
shares under the Securities Exchange Act of 1934, as amended. UniSource Energy's
and TEP's headquarters will remain in Tucson, and we expect that UniSource
Energy's and TEP's senior management team will remain generally in place.
Upon the closing of the acquisition, Saguaro Utility will cause the
surviving corporation to pay approximately $880 million in cash to UniSource
Energy's shareholders and holders of stock options, stock units, restricted
stock and performance shares awarded under our stock based compensation plans.
In connection with the closing of the acquisition, Saguaro Utility intends to
cause the surviving corporation (i) to repay the $95 million intercompany loan
to UniSource Energy from TEP and (ii) to contribute up to $168 million to TEP.
TEP will use a significant portion of these proceeds to retire some of its
outstanding debt.
We expect that the proceeds for all of the above mentioned payments
will come from a combination of equity contributions by the partners of Saguaro
Utility and borrowings and issuances of debt securities by another affiliate of
Saguaro Acquisition Corp. We expect the partners of Saguaro Utility to
contribute approximately $557 million to Saguaro Utility, which will contribute
the net proceeds to Saguaro Acquisition Corp. immediately prior to the
acquisition. We expect that the remaining proceeds necessary to finance this
transaction will be obtained by Saguaro Acquisition Corp.'s affiliate, at the
closing of the acquisition, through a $360 million borrowing from a syndicate of
lenders and an issuance of $300 million in notes. Saguaro Acquisition Corp. and
its affiliate obtained commitments from lenders for the $360 million in
borrowings. In addition, Saguaro Acquisition Corp. and its affiliate obtained
commitments for (i) a $50 million revolving credit facility for general
corporate purposes, (ii) a $40 million revolving credit facility for UES and
(iii) a loan to refinance TEP's existing Credit Facility. Each of these
commitments expires February 21, 2005, and is subject to various closing
conditions customary for bank commitment letters in connection with an
acquisition of this type. Saguaro Acquisition Corp. and its affiliate also
obtained a letter from a group of investment banks that they were highly
confident that they could arrange for the sale of up to $300 million in notes
of the affiliate through a private sale and/or a public offering. The letter
from the investment banks relating to the sale of the $300 million in notes is
not a commitment or undertaking by such banks to underwrite, place or purchase
the notes or otherwise provide financing.
The acquisition is subject to several closing conditions, including
without limitation, (i) the absence of any material adverse effect in the
business, properties, assets, condition, prospects or results of operations of
UniSource Energy and its subsidiaries taken together as a whole; (ii) the
receipt of the required shareholder approval; (iii) the receipt of required
regulatory approvals; (iv) that no final order with respect to any regulatory
approval necessary to effect the acquisition either (A) has or could reasonably
be expected to have a material adverse effect on us or Saguaro Utility or (B)
causes or could reasonably be expected to cause the rates of any of our utility
subsidiaries to be less favorable than the rates that were in effect on the date
of the acquisition agreement; (v) that restrictions on the ability of TEP to pay
dividends of all of its net income be effectively eliminated; and (vi) that
Saguaro Acquisition Corp. receives its financing for the acquisition on terms
and conditions that, in the reasonable judgment of Saguaro Acquisition Corp.,
are comparable to, or more favorable to Saguaro Acquisition Corp. in the
aggregate than the terms and conditions contemplated by the acquisition
agreement.
UniSource Energy's shareholders of record will formally consider a
proposal to approve the acquisition agreement at a special meeting scheduled for
March 29, 2004. The acquisition is also subject to the receipt of certain
regulatory approvals, including ACC approval, SEC approval under the Public
Utility Holding Company Act of 1935, as amended, FERC approval and approval
under federal antitrust laws. We filed an application with the ACC for approval
of the acquisition on December 29, 2003. We expect the acquisition to close in
the second half of 2004.
The acquisition agreement contains operating covenants with respect to
the operations of our business pending the consummation of the acquisition.
Generally, unless UniSource Energy obtains Saguaro Acquisition Corp.'s prior
written consent, we must carry on our business in the ordinary course consistent
with past practice and use all commercially reasonable efforts to preserve
substantially intact our present business organization and present regulatory,
business and employee relationships. In addition, the acquisition agreement
restricts
K-2
our activities, subject to the receipt of Saguaro Acquisition Corp.'s
prior written consent, including the issuance or repurchase of capital stock,
the amendment of organizational documents, acquisitions and dispositions of
assets, capital expenditures, incurrence of indebtedness, modification of
employee compensation and benefits, changes in accounting methods, discharge of
liabilities, and matters relating to UniSource Energy's investment in
Millennium. For a more complete understanding of these restrictions we encourage
you to read the acquisition agreement which UniSource Energy has previously
filed with the SEC and is publicly available.
Either UniSource Energy or Saguaro Acquisition Corp. may terminate the
acquisition agreement in certain circumstances, including if not consummated by
March 31, 2005, certain regulatory approvals are not obtained or if our
shareholders do not approve the acquisition. In certain circumstances, upon the
termination of the acquisition agreement, UniSource Energy would be required to
pay Saguaro Acquisition Corp.'s expenses and a termination fee in an aggregate
amount of up to $25 million.
As a result of the approval of the acquisition by UniSource Energy's
Board of Directors, the acquisition will not trigger the provisions of UniSource
Energy's shareholder rights plan or the restrictions on "business combinations"
or "control share acquisitions" under the Arizona Business Corporation Act.
BUSINESS SEGMENT CONTRIBUTIONS
The table below shows the contributions to our consolidated after-tax
earnings by our four business segments, as well as parent company expenses.
2003 2002 2001
---------------------------------------------------------------- ------------ ----------- -----------
Business Segment - Millions of Dollars -
TEP (1) $128 $ 54 $ 75
UES (2) 3 - -
Millennium (16) (16) (9)
UED 7 1 1
UniSource Energy Standalone (3) (9) (6) (6)
---------------------------------------------------------------- ------------ ----------- -----------
Consolidated Net Income $113 $ 33 $ 61
================================================================ ============ =========== ===========
(1) TEP results in 2003 include an after-tax gain of $67 million for
the Cumulative Effect of Accounting Change from the adoption of
Statement of Financial Accounting Standards No. 143, Accounting for
Asset Retirement Obligations (FAS 143).
(2) Results are for the period from August 11, 2003 to December 31,
2003.
(3) Primarily represents interest expense (net of tax) on the note
payable from UniSource Energy to TEP, as well as costs in 2003
associated with the Citizens acquisition and the proposed acquisition
of UniSource Energy as previously discussed.
The electric utility industry has undergone significant regulatory
change in recent years. See Item 7. - Management's Discussion and Analysis of
Financial Condition and Results of Operations, Outlook and Strategies, for a
discussion of our plans and strategies to remain competitive and flexible in
this changing environment and Rates and Regulation, below, for the status of
competition in Arizona.
References in this report to "we" and "our" are to UniSource Energy and
its subsidiaries, collectively.
TEP ELECTRIC UTILITY OPERATIONS
TEP was incorporated in the State of Arizona on December 16, 1963. TEP
is the successor by merger as of February 20, 1964, to a Colorado corporation
that was incorporated on January 25, 1902. TEP is the principal operating
subsidiary of UniSource Energy. In 2003, TEP's electric utility operations
contributed 88% of UniSource Energy's operating revenues and comprised 86% of
its assets.
K-3
SERVICE AREA AND CUSTOMERS
TEP is a vertically integrated utility that provides regulated electric
service to more than 367,000 retail customers in Southeastern Arizona. TEP's
service territory consists of a 1,155 square mile area and includes a population
of approximately 911,000 in the greater Tucson metropolitan area in Pima County,
as well as parts of Cochise County. TEP holds a franchise to provide electric
distribution service to customers in the Cities of Tucson and South Tucson.
These franchises expire in 2026 and 2017, respectively. TEP also sells
electricity to other utilities and power marketing entities in the western U.S.
RETAIL CUSTOMERS
In 2003, TEP's number of retail customers increased by 2.2% and total
retail energy consumption increased by approximately 3%. The table below shows
the percentage distribution of TEP's energy sales by major customer class over
the last three years.
2003 2002 2001
---- ---- ----
Residential 41% 40% 38%
Commercial 20% 20% 19%
Non-mining Industrial 27% 28% 27%
Mining 9% 9% 13%
Public Authority 3% 3% 3%
TEP expects that its peak demand, number of retail customers and retail
energy consumption will increase 2 - 3% annually through 2007. The retail energy
consumption by customer class is expected to be similar to the 2003
distribution.
Beginning January 1, 2001, all of TEP's retail customers were eligible
to choose alternative energy providers. Even though some of TEP's retail
customers may choose other energy providers, the forecasted customer growth
rates referred to above would continue to apply to its distribution business. At
March 10, 2004, none of TEP's customers are being served by an alternative
energy provider. See Rates and Regulation, State, below.
Sales to Large Industrial Customers
TEP provides electric utility service to a diverse group of commercial,
industrial, and public sector customers. Major industries served include copper
mining, cement manufacturing, defense, health care, education, military bases
and other governmental entities. Local, regional, and national economic factors
can impact the financial condition and operations of TEP's large industrial
customers. Such economic conditions may directly impact energy consumption by
large industrial customers, and may indirectly impact residential and small
commercial sales and revenues if employment levels and consumer spending are
affected.
Two of TEP's largest retail customers are in the copper mining
industry. TEP has contracts with its two mining customers to provide electric
service at negotiated rates. These contracts expire in 2006 and 2008. TEP's
sales to mining customers depend on a variety of factors including changes in
supply and demand in the world copper market and the economics of
self-generation. Average U.S. copper prices have ranged between $0.62 and $1.00
per pound during the last five years. As a result of low copper prices in 2002
and 2003, TEP's mining customers reduced operations during those years and
correspondingly reduced energy consumption. Since October 2003, U.S. copper
prices have risen steadily and were approximately $1.19 per pound in February
2004. One of TEP's mining customers announced in January 2004, it would be
increasing its energy requirements by approximately 15 MW this year.
WHOLESALE BUSINESS
TEP's electric utility operations include the wholesale marketing of
electricity to other utilities and power marketers. Wholesale sales transactions
are made on both a firm and interruptible basis. A firm basis means that
contractually, TEP must supply the power (except under limited emergency
circumstances), while an interruptible basis means that TEP may stop supplying
power under defined conditions. See Other Purchases and Interconnections, below.
K-4
TEP typically uses its own generation to serve the requirements of its
retail and long-term wholesale customers. Generally, TEP commits to future sales
based on expected excess generating capability, forward prices and generation
costs, using a diversified portfolio approach to provide a balance between
long-term, mid-term and spot energy sales. When TEP expects to have excess
generating capacity (usually in the first, second and fourth calendar quarters),
its wholesale sales consist primarily of three types of sales:
(1) Sales under long-term contracts for periods of more than one year.
TEP currently has long-term contracts with three entities to sell
firm capacity and energy: Salt River Project Agricultural
Improvement and Power District (SRP), the Navajo Tribal Utility
Authority and the Tohono O'odham Utility Authority. TEP also has a
multi-year interruptible contract with Phelps Dodge Energy
Services, which requires a fixed contract demand of 60 MW at all
times except during TEP's peak customer energy demand period, from
July through September of each year. Under the contract, TEP can
interrupt delivery of power if TEP experiences significant loss of
any electric generating resources.
(2) Other sales include forward sales and short-term sales. Under
forward contracts, TEP commits to sell a specified amount of
capacity or energy at a specified price over a given period of
time, typically for one-month, three-month or one-year periods.
Under short-term sales, TEP sells energy in the daily or hourly
markets at fluctuating spot market prices and other non-firm
energy sales.
(3) Sales of transmission service.
TEP purchases power in the wholesale markets when economic. TEP may
enter into forward contracts: (a) to purchase energy under long-term contracts
to serve retail load and long-term wholesale contracts, (b) to purchase capacity
or energy during periods of planned outages or for peak summer load conditions,
and (c) to purchase energy to resell to certain wholesale customers under load
and resource management agreements. Finally, TEP may purchase energy in the
daily and hourly markets to meet higher than anticipated demands, to cover
unplanned generation outages, or when it is more economical than generating its
own energy.
As a participant in the western U.S. wholesale power markets, TEP is
affected by changes impacting these markets and market participants. In 2001, a
significant portion of TEP's revenues and earnings resulted from its wholesale
marketing activities (including unrealized gains or losses on sales and
purchases of energy), which benefited from strong demand and high wholesale
prices in the western U.S. These market conditions were the result of a number
of factors, including power supply shortages, high natural gas prices, and
transmission and environmental constraints. During this period, these markets
experienced unprecedented price volatility, as well as payment defaults and
bankruptcies by several of its largest participants. Regulatory agencies became
concerned with the outcomes of deregulation of the electric power industry and
intervened in the operation of these markets by, among other things, imposing
price caps and initiating investigations into potential market manipulation.
Since mid-2001, conditions in the western U.S. energy markets have
changed significantly as a result of various regulatory actions, the addition of
new generation in the region and other factors. In addition, the presence of
fewer creditworthy counterparties, as well as legal, political and regulatory
uncertainties has reduced market liquidity and trading volume. Several companies
that were large market participants have either curtailed their activities or
exited the business completely. These factors placed downward pressure on
wholesale electricity prices, and resulted in significantly lower wholesale
electricity sales and revenues at TEP in 2002 and 2003.
In the first quarter of 2003, both the natural gas and western U.S.
wholesale electricity markets experienced some price spikes and volatility due
to severe winter weather. Gas and power prices remained high throughout 2003 due
to continued gas production and storage concerns. TEP cannot predict, however,
whether gas and wholesale electricity prices will remain elevated and what the
impact will be on TEP's sales and revenues in 2004.
TEP expects to continue to be a participant in the wholesale energy
markets, primarily by making sales and purchases in the short-term and forward
markets. TEP expects the market price in the western U.S. and demand for
capacity and energy to continue to be influenced by the following factors, among
others, during the next few years:
K-5
o continued population growth;
o economic conditions in the western U.S.;
o availability of generation capacity throughout the western U.S.;
o the extent of electric utility industry restructuring in Arizona,
California and other western states;
o the effect of FERC regulation of wholesale energy markets;
o the availability and price of natural gas;
o availability of hydropower;
o transmission constraints; and
o environmental requirements and the cost of compliance.
See Item 7. - Management's Discussion and Analysis of Financial
Condition and Results of Operations, Tucson Electric Power Company, Factors
Affecting Results of Operations, Western Energy Markets, for additional
discussion of TEP's wholesale marketing activities.
GENERATING AND OTHER RESOURCES
TEP GENERATING Resources
At December 31, 2003, TEP owned or leased 2,003 MW of net generating
capability as set forth in the following table:
Net
Unit Fuel Owned/ Capability Operating TEP's Share
Generating Source No. Location Type Leased MW Agent
% MW
- ---------------------------------------------------------------------------------------------------------------------------
Springerville Station 1 Springerville, AZ Coal Leased 380 TEP 100.0 380
Springerville Station 2 Springerville, AZ Coal Owned 380 TEP 100.0 380
San Juan Station 1 Farmington, NM Coal Owned 327 PNM 50.0 164
San Juan Station 2 Farmington, NM Coal Owned 316 PNM 50.0 158
Navajo Station 1 Page, AZ Coal Owned 750 SRP 7.5 56
Navajo Station 2 Page, AZ Coal Owned 750 SRP 7.5 56
Navajo Station 3 Page, AZ Coal Owned 750 SRP 7.5 56
Four Corners Station 4 Farmington, NM Coal Owned 784 APS 7.0 55
Four Corners Station 5 Farmington, NM Coal Owned 784 APS 7.0 55
Sundt Station 1 Tucson, AZ Gas/Oil Owned 81 TEP 100.0 81
Sundt Station 2 Tucson, AZ Gas/Oil Owned 81 TEP 100.0 81
Sundt Station 3 Tucson, AZ Gas/Oil Owned 104 TEP 100.0 104
Sundt Station 4 Tucson, AZ Coal/Gas Leased 156 TEP 100.0 156
Internal Combustion Turbines Tucson, AZ Gas/Oil Owned 122 TEP 100.0 122
Internal Combustion Turbines Tucson, AZ Gas Owned 95 TEP 100.0 95
Solar Electric Generation Springerville/ Solar Owned 4 TEP 100.0 4
Tucson, AZ
- ---------------------------------------------------------------------------------------------------------------------------
Total TEP Capacity (1) 2,003
===========================================================================================================================
(1) Excludes 486 MW of additional resources, which consist of certain capacity
purchases and interruptible retail load. At December 31, 2003, total owned
capacity was 1,467 MW and leased capacity was 536 MW.
The Springerville Generating Station, located in northeast Arizona,
consists of two coal-fired units. Springerville Unit 1 began commercial
operation in 1985 and is leased and operated by TEP. Springerville Unit 2
started commercial operation in June 1990 and is owned by TEP's wholly-owned
subsidiary, San Carlos Resources Inc. (San Carlos), and operated by TEP. These
units are rated at 380 MW for continuous operation. The Springerville Station
was originally designed for four generating units. UED currently manages the
construction of Unit 3, which will be 100% leased by a financial owner to
Tri-State Generation and Transmission Association (Tri-State). Construction of
Unit 3 began in October 2003. We expect commercial operation of Unit 3 to occur
in December 2006. TEP will operate the unit. SRP has the right to construct and
own Unit 4 at a later date. See UniSource Energy Development Company, below.
The Springerville Generating Station also includes the Springerville
Coal Handling Facilities and the Springerville Common Facilities. In 1984, TEP
sold and leased back the Springerville Coal Handling Facilities. In 1985, TEP
sold and leased back a 50% interest in the Springerville Common Facilities. The
other 50% interest is included in the Springerville Unit 1 leases.
K-6
TEP obtains approximately 600 MW, or 30%, of its generating capacity
from jointly-owned facilities at the San Juan, Four Corners, and Navajo
Generating Stations in New Mexico and northern Arizona.
The Sundt Generating Station (Sundt) includes four units located in
Tucson, Arizona. Units 1, 2 and 3 are gas or oil burning units. Sundt Unit 4
operates primarily on coal in combination with natural gas or landfill gas, but
it is also able to operate solely on natural gas. Units 1, 2, and 3 are
wholly-owned by TEP, and Unit 4 is leased. The Sundt Generating Station and the
internal combustion turbines located in Tucson are designated as "must-run
generation" facilities. Must-run generating units are those which are required
to run in certain circumstances to maintain distribution system reliability and
meet local load requirements.
See Note 10 of Notes to Consolidated Financial Statements, and Item 7.
- - Management's Discussion and Analysis of Financial Condition and Results of
Operations, Tucson Electric Power Company, Liquidity and Capital Resources,
Contractual Obligations, for more information regarding the Springerville and
Sundt leases.
POWER EXCHANGE AGREEMENT
TEP and Southern California Edison Company (SCE) have a ten-year power
exchange agreement which requires SCE to provide firm system capacity of 110 MW
to TEP during the summer months. TEP is then obligated to return to SCE in the
winter months the same amount of energy that TEP received during the preceding
summer. For example, in the summer of 2003, TEP received approximately 136,000
MWh from SCE and returned the same amount during the winter months from November
2003 to February 2004. This agreement expires in February 2005. The net
incremental increase in cost due to the loss of the SCE exchange agreement is
expected to be less than $2 million annually. We expect to purchase additional
resource needs through a competitive bidding process and short-term purchases.
OTHER PURCHASES AND INTERCONNECTIONS
TEP purchases additional electric energy from other utilities and power
marketers. The amount of energy purchased varies substantially from time to time
depending on the demand for energy, the cost of purchased energy compared with
TEP's cost of generation, and the availability of such energy. TEP may also sell
electric energy in the wholesale market. See also Wholesale Business, above and
Item 7. - Management's Discussion and Analysis of Financial Condition and
Results of Operations, Tucson Electric Power Company, Factors Affecting Results
of Operations, below.
TEP is a member of various regional reserve sharing, reliability and
power sharing organizations. These relationships allow TEP to call upon other
utilities during emergencies such as plant outages and system disturbances, and
reduce the amount of reserves TEP is required to carry.
PEAK DEMAND AND RESOURCES
Peak Demand 2003 2002 2001 2000 1999
---------- ---------- ---------- ---------- ----------
-MW-
Retail Customers-Net One Hour 2,060 1,899 1,840 1,862 1,754
Firm Sales to Other Utilities 171 228 151 143 178
----------------------------------------------- ---------- ---------- ---------- ---------- ----------
Coincident Peak Demand (A) 2,231 2,127 1,991 2,005 1,932
Total Generating Resources 2,003 2,002 1,999 1,904 1,904
Other Resources (1) 486 308 217 248 235
----------------------------------------------- ---------- ---------- ---------- ---------- ----------
Total TEP Resources (B) 2,489 2,310 2,216 2,152 2,139
Total Margin (B) - (A) 258 183 225 147 207
Reserve Margin (% of Coincident
Peak Demand) 12% 9% 11% 7% 11%
----------------------------------------------- ---------- ---------- ---------- ---------- ----------
(1) Other Resources includes firm power purchases and interruptible
retail and wholesale loads.
TEP's retail sales are influenced by several factors, including
seasonal weather patterns, competitive conditions and the overall economic
climate. The peak demand occurs during the summer months due to the
K-7
cooling requirements of TEP's retail customers. Retail peak demand has grown at
an average annual rate of approximately 4% from 1999 to 2003.
The chart above shows the relationship over a five-year period between
TEP's peak demand and its energy resources. TEP's margin is the difference
between total energy resources and coincident peak demand, and the reserve
margin is the ratio of margin to coincident peak demand. TEP maintains a minimum
reserve margin in excess of 7% to comply with reliability criteria set forth by
the Western Electricity Coordinating Council (WECC), (formerly the Western
Systems Coordinating Council). TEP's actual reserve margin in 2003 was 12%.
In 2003, TEP entered into two power purchase agreements for the period
2003 through 2006 as listed below:
o PPL Energy Plus, LLC supplied 37 MW from June 2003 through December
2003 and will supply 75 MW from January 2004 through December 2006,
under a unit contingent contract.
o Panda Gila River generating station will supply 50 MW on-peak for the
June through September time period, from 2003 (which has been supplied)
through 2005, under a unit contingent contract between TEP and Panda
Gila River, L.P.
We believe these and other short-term purchases will provide adequate
reserve margins during the summer peak period.
Forecasted retail peak demand for 2004 is approximately 2,083 MW,
compared with actual peak demand of 2,060 MW in 2003. Except for certain peak
hours during the summer, TEP believes it has sufficient resources to meet
expected demand in 2004 with its existing generation and power purchase
agreements.
See Future Generating Resources, TEP, below and Rates and Regulation,
State, Track B, below.
FUTURE GENERATING RESOURCES -- TEP
In the past, TEP assessed its need for future generating resources
based on the premise of a continued regulatory requirement to serve customers in
TEP's retail service area. However, the ACC's electric competition rules, as
currently in effect, modified the obligation to provide generation services to
all customers. These rules and TEP's ability to retain and attract customers
will affect the need for future resources. For those customers who do not choose
other energy providers, TEP remains obligated to supply energy. However, TEP is
not obligated to supply this energy from TEP-owned generating assets. The energy
may be acquired through purchase in the wholesale markets. See Rates and
Regulation, Recent Arizona Court of Appeals Decision below and Item 7. -
Management's Discussion and Analysis of Financial Condition and Results of
Operations, Tucson Electric Power Company, Factors Affecting Results of
Operations, Competition, below.
TEP will continue to add peaking resources in the Tucson area as needed
based upon our forecasts of retail and firm wholesale load, as well as the
statewide transmission infrastructure. TEP currently forecasts that new peaking
resources of 75 MW may be needed in both 2008 and 2010. In conjunction with the
expansion of the Springerville Generating Station, TEP entered into a power
purchase contract with Tri-State for up to 100 MW of capacity from Tri-State's
system resources. This contract with Tri-State is for up to five years,
beginning with commercial operation of Unit 3, expected in December 2006. TEP
anticipates that any power purchased under this contract will be sold in the
wholesale markets. If power purchased under this contract is to be used by TEP
to serve its retail load, TEP must comply with the Track B competitive bidding
procedures established by the ACC. See UniSource Energy Development Company,
below and Rates and Regulation, State, Track B, below.
FUEL SUPPLY
TEP purchases coal and natural gas in the normal course of business to
fuel its generating plants. The majority of its coal supplies are purchased
under long-term contracts, which result in more predictable prices.
TEP's principal fuel for electric generation is low-sulfur coal. Fuel
information is provided below:
K-8
Average Cost per MMBtu Consumed Percentage of Total BTU Consumed
- --------------- ------------- ----------- ----------- -- ----------- ------------- ------------
2003 2002 2001 2003 2002 2001
Coal (A) $1.58 $1.59 $1.63 96% 94% 90%
Gas 6.38 4.28 5.99 4 6 10
All Fuels $1.79 $1.76 $2.08 100% 100% 100%
- --------------- ------------- ----------- ----------- -- ----------- ------------- ------------
(A) The average cost per ton of coal for 2003, 2002, and 2001 was $30.31,
$30.86, and $30.96, respectively.
TEP'S COAL AND GAS SUPPLY
Year Contract Average
Terminates Sulfur
Station Coal Supplier Content Coal Obtained From (A)
- --------------------- ------------------------------------ --------------- ----------- -----------------------------------
Springerville Peabody Coalsales Company 2020 0.9% Lee Ranch Coal Company
Four Corners BHP Billiton 2016 0.8% Navajo Indian Tribe
San Juan San Juan Coal Company 2017 0.8% Federal and State Agencies
Navajo Peabody Coalsales Company 2011 0.6% Navajo and Hopi Indian Tribes
Sundt Various approved suppliers 2006 - Various locations
- --------------------- ------------------------------------ --------------- ----------- -----------------------------------
(A) Substantially all of the suppliers' mining leases extend at least as long as
coal is being mined in economic quantities.
TEP Operated Generating Facilities
TEP is the sole owner (or lessee) and operator of the Springerville and
Sundt Generating Stations. The coal supplies for these plants are transported
from northwestern New Mexico and Colorado by railroad.
In October 2003, TEP amended and extended the long-term coal supply
contract for Springerville Units 1 and 2 through 2020. We expect coal reserves
to be sufficient to supply the estimated requirements for Units 1 and 2 for
their presently estimated remaining lives. We estimate future minimum annual
payments under this contract to be $45 million through 2010, the initial
contract expiration date, and $14 million in 2011 through 2020. TEP's coal
transportation contract at Springerville runs through 2011. We estimate minimum
annual payments under this contract to be $13 million through 2010 and $7
million in 2011.
In July 2002, TEP terminated the long-term coal supply contract for the
Sundt Generating Station. TEP incurred a pre-tax charge of $11 million related
to the cost of terminating this contract. The termination fee relieved TEP of up
to $3 million in annual pre-tax take-or-pay payments.
In the fourth quarter of 2003, TEP entered into agreements for the
purchase and transportation of coal to the Sundt Generating Station through
2006. The total amount paid under these agreements depends on the number of tons
of coal purchased and transported. The coal agreements require TEP to take
300,000 tons annually with estimated future minimum payments of $4 million in
2004 and $6 million in 2005 and 2006. The rail agreement requires TEP to
transport 300,000 tons with estimated future minimum payments of $2 million in
each year from 2004 through 2006.
The rail contract for the Sundt Generating Station is in effect until
the earliest of 2015 or the remaining life of Unit 4. The rail contract requires
TEP to transport at least 75,000 tons of coal per year through 2015 at an
estimated annual cost of $2 million or to make a minimum payment of $1 million.
TEP expects to use the rail contracts for at least the minimum delivery amounts
through at least 2006. See Note 15 of Notes to Consolidated Financial Statements
- Commitments and Contingencies, TEP Commitments, Purchase and Transportation
Commitments.
Generating Facilities Operated by Others
TEP also participates in jointly-owned generating facilities at Four
Corners, Navajo and San Juan, where coal supplies are under long-term contracts
administered by the operating agents. In July 2003, the Four Corners coal
contract was extended through July 2016. This contract requires TEP to purchase
minimum
K-9
amounts of coal at an estimated annual cost of $5 million for the next 13 years.
We expect coal reserves available to these three jointly-owned generating
facilities to be sufficient for the remaining lives of the stations.
In September 2000, TEP terminated the San Juan Generating Station's
coal supply contract and entered into a new coal supply contract, replacing two
surface mining operations with one underground operation. San Juan Coal Company,
the coal supplier to San Juan, commenced development of the underground mine in
the fourth quarter of 2000 with full station supply expected in March 2003. The
underground mine did not achieve full station supply until December 2003 due to
geological issues. PNM, TEP, and San Juan Coal Company have begun a review of
long term coal cost projections given the production issues encountered and the
experience gained from mining operations.
The contracts to purchase coal for use at the jointly-owned facilities
require TEP to purchase minimum amounts of coal at an estimated average annual
cost of $19 million for the next five years.
Natural Gas
TEP typically uses generation from its facilities fueled by natural gas
to meet the summer peak demands of its retail customers and to meet local
reliability needs. Due to its increasing seasonal gas usage, TEP hedges a
portion of its natural gas purchases with fixed price contracts for a maximum of
three years, and purchases its remaining gas needs in the spot and short-term
markets through its supplier Southwest Gas Corporation (SWG). TEP entered into a
Gas Procurement Agreement with SWG effective June 1, 2001 with a primary term of
five years. The contract provided for a minimum volume obligation during the
first two years of 10 million MMBtu's annually. TEP negotiated new pricing and a
lower minimum annual volume obligation of 4 million MMBtu's for 2004 and TEP
expects to use more gas than this minimum requirement. In the event fewer
MMBtu's are purchased, TEP is obligated to pay only the transportation component
for any shortfall. TEP will negotiate terms for the remaining two years of the
contract in late 2004. TEP made payments under this contract of $34 million in
2003, $33 million in 2002 and $28 million in 2001.
In 2003, the average market price of natural gas at the San Juan basin
was $4.42 per MMBtu, or 68% higher than 2002, due to low gas storage levels and
reductions in gas production. The increase in the regional supply of
gas-generated energy and the completion of a 500-kV transmission connection,
however, allowed TEP to decrease use of its less efficient gas generation units
in favor of more economical purchases of energy in the wholesale market. TEP's
generation output fueled by natural gas was approximately 433,000 MWh, or 4% of
total generation in 2003, compared with approximately 720,000 MWh, or 6% of
total generation in 2002. In 2003, TEP purchased approximately 125,000 MWh of
gas-fired energy under long-term purchased power contracts. The majority of the
energy purchased under these agreements is adjusted for changes in the price of
natural gas. See Rates and Regulation, State, Track B, below for discussion of
purchased power contracts.
WATER SUPPLY
Drought conditions in the Four Corners region, combined with water
usage in upper New Mexico, have resulted in decreasing water levels in the lake
that indirectly supplies water to the San Juan and Four Corners Generating
Stations. These drought conditions may affect the water supply of the plants in
the future if adequate moisture is not received in the watershed that supplies
the area. The moisture levels in the region during the 2003-2004 winter season
have been above historic averages. TEP has a 50% ownership interest in each of
San Juan units 1 and 2 (322 MW capacity) and a 7% ownership interest in each of
Four Corners units 4 and 5 (110 MW capacity).
PNM, the operating agent for San Juan, has negotiated supplemental
water contracts with the U.S. Bureau of Reclamation and the Jicarilla Apache
Nation to assist San Juan in meeting its water requirements in the event of a
water shortage. TEP does not believe that its operations will be materially
affected by this drought. However, TEP cannot predict the ultimate outcome of
the drought, or whether it will adversely affect the amount of power available
from the San Juan and Four Corners Generating Stations.
K-10
TRANSMISSION ACCESS
TEP has transmission access and power transaction arrangements with
over 120 electric systems or suppliers. In May 2003, TEP completed construction
of a one mile 500-kV transmission line and related substations to enhance its
distribution system link to the regional high voltage transmission system.
Tucson to Nogales Transmission Line
In January 2001, TEP and Citizens (now UES) entered into a project
development agreement for the joint construction of a 62-mile transmission line
from Tucson to Nogales, Arizona. In January 2002, the ACC approved the location
and construction of the proposed 345-kV line. TEP is currently seeking approvals
for the project from the Department of Energy (DOE), the U.S. Forest Service,
the U.S. Bureau of Land Management, and the International Boundary and Water
Commission. The DOE has completed a draft Environmental Impact Statement (EIS)
for the project which identified the ACC-approved Western Corridor route as its
preferred alternative. We expect to receive a final EIS in 2004. The DOE will
use the EIS to help it decide whether to issue a Presidential Permit that would
allow TEP to extend the line across the border into Mexico. Other federal
agencies will also use the EIS for their own permitting processes. The
construction costs to Nogales, Arizona are expected to be approximately $75
million. Through December 31, 2003, approximately $9 million in engineering and
environmental expenses have been capitalized related to this project. If the
transmission line does not proceed, these costs would be immediately expensed.
Regional and Federal Transmission Issues
In 1997, TEP and other transmission owners and users located in the
southwestern U.S. began to investigate the feasibility of forming an Independent
System Operator (ISO) for the region. In December 1999, the FERC issued FERC
Order 2000, which established timelines for all transmission owning entities to
join a Regional Transmission Organization (RTO) and defined the minimum
characteristics and functions of an RTO. TEP and three other southwestern
utilities filed agreements and operating protocols with the FERC in October 2001
to form a new, for-profit RTO to be known as WestConnect RTO, LLC (WestConnect).
WestConnect will be responsible for security, reservations, scheduling,
transmission expansion and planning, and congestion management for the regional
transmission system. It will also focus on ensuring reliability,
nondiscriminatory open-access, and independent governance. Regional transmission
owners would have the option, but not be required, to transfer ownership of
transmission assets to the RTO. At present, TEP intends to turn over only
operating control of its transmission assets to the RTO. Additionally, the RTO
may build new transmission lines in the region, which could be owned by the RTO.
In October, 2002, the FERC issued a provisional order approving, in
part, the WestConnect RTO proposal. The FERC also required WestConnect, along
with the other two RTOs in the western region (the California Independent System
Operator (CISO) and RTO West), to participate in a steering group to encourage
the development of a seamless wholesale electric energy market. WestConnect's
operation is dependent on the resolution of these issues and is also subject to
approval by state regulatory agencies. WestConnect is following a phased
approach for development that will progress from development of a regional Open
Access Same Time Information System (OASIS) to full RTO implementation in three
or four phases. The first phase includes the regional OASIS (to be called
WesTTrans) and an energy posting system that will be operational on April 1,
2004. The WesTTrans system includes the WestConnect participants as well as some
other public power entities throughout the west. WestConnect is currently
developing its phasing plans.
On July 31, 2002, the FERC issued a Notice of Proposed Rulemaking
(NOPR) proposing standard market design rules that would significantly alter the
markets for wholesale electricity and transmission and ancillary services in the
U.S. The new rules would establish a generation adequacy requirement for
"load-serving entities" and a standard platform for the sale of electricity and
transmission services. Under the new rules, Independent Transmission Providers
would administer spot markets for wholesale power, ancillary services and
transmission congestion rights, and electric utilities, including TEP, would be
required to transfer control over transmission facilities to the applicable
Independent Transmission Provider. The FERC released a white paper on the
standard market design in 2003. This effort by FERC provoked extensive response
from the industry as well as state regulators, stalling the standard market
design effort.
In late 2003, FERC issued a final rule on Standards of Conduct that
apply equally to natural gas and
K-11
electricity. These rules expand on existing
requirements that utilities must follow regarding non-discriminatory treatment
of customers.
RATES AND REGULATION
The FERC and the ACC regulate portions of TEP's utility accounting
practices and electricity rates. The FERC regulates the terms and prices of
TEP's transmission services and sales of electricity at wholesale. In 1996, TEP
filed a tariff at FERC governing the rates, terms and conditions of open access
transmission services. In 1997, TEP was granted a FERC tariff to sell power at
market based rates. The ACC has authority over rates charged to retail
customers, the issuance of securities, and transactions with affiliated parties.
STATE
Historically, the ACC determined TEP's rates for retail sales of
electric energy on a "cost of service" basis, which was designed to provide,
after recovery of allowable operating expenses, an opportunity to earn a
reasonable rate of return on TEP's "fair value rate base." Fair value rate base
was generally determined by reference to the original cost and the
reconstruction cost (net of depreciation) of utility plant in service to the
extent deemed used and useful, and to various adjustments for deferred taxes and
other items, plus a working capital component. Over time, rate base was
increased by additions to utility plant in service and reduced by depreciation
and retirements of utility plant.
TEP's Settlement Agreement and Retail Electric Competition Rules
In September 1999, the ACC approved the Retail Electric Competition
Rules (Rules) that provided a framework for the introduction of retail electric
competition in Arizona. In November 1999, the ACC approved the Settlement
Agreement between TEP and certain customer groups related to the implementation
of retail electric competition in Arizona.
The Rules and TEP's Settlement Agreement required the unbundling of
electric services, with separate rates or prices for generation, transmission,
distribution, metering, meter reading, billing and collection, and ancillary
services. Generation services at market prices may be provided by Energy Service
Providers (ESPs) licensed by the ACC. Transmission and distribution services and
must-run generation facilities will remain subject to regulation on a cost of
service basis. TEP has met all conditions required by the ACC to facilitate
electric retail competition, including ACC approval of TEP's direct access
tariffs. However, ESPs and their related service providers must meet certain
conditions before they can competitively sell electricity in TEP's service
territory. Examples of these conditions include ACC certification of ESPs and
completion of direct access service agreements with TEP.
The Settlement Agreement also provided for certain retail rate
reductions from 1998 through 2000. In addition, TEP is required to file by June
1, 2004 a general rate case, including an updated cost of service study. Under
the terms of the Settlement Agreement, no rate case filed by TEP through 2008,
including the rate case to be filed by June 1, 2004, may result in a net rate
increase. Any rate decrease resulting from this rate case would be effective no
sooner than June 1, 2005.
The ACC order approving the Citizens acquisition also requires that TEP
submit as part of its June 2004 general rate case filing, a feasibility study
and consolidation plan, or in the alternative, a plan for coordination of
operations of UNS Electric's operations in Santa Cruz County with those of TEP.
During 2002, the ACC reexamined circumstances that had changed since it
approved the Rules in 1999. The outstanding issues were divided into two groups.
Track A related primarily to the divestiture of generation assets while Track B
related primarily to the competitive energy bidding process.
Track A
In September 2002, the ACC issued the Track A Order, which eliminated
the requirement in the TEP Settlement Agreement that TEP transfer its generation
assets to a subsidiary. At the same time, the ACC ordered the parties, including
TEP, to develop a competitive bidding process, and reduced the amount of power
to be acquired in the competitive bidding process to only that portion not
supplied by TEP's existing resources.
K-12
Track B
On February 27, 2003, the ACC issued the Track B Order, which defined
the competitive bidding process TEP must use to obtain capacity and energy
requirements beyond what is supplied by TEP's existing resources. For the period
2003 through 2006, TEP estimated these amounts to be 50,000 MWh of energy in
2003, or approximately 0.5% of its retail load, gradually increasing to 104,000
MWh by 2006. The Track B Order further required TEP to bid out "Economy Energy",
or short-term energy purchases, that it estimates it will make in the 2003 to
2006 period (210,000 to 181,000 MWh).
TEP was also required to bid out its Reliability Must Run (RMR)
generation requirements, which are currently met by its existing local
generation units. TEP's RMR generation requirements are estimated at 471 MW of
capacity and 37,000 MWh of energy in 2003 increasing to 687 MW of capacity and
38,000 MWh of energy in 2005. TEP does not anticipate that any near-term RMR
requirements will be met through this competitive bidding process because of the
locational and operational requirements of TEP's RMR generation as well as TEP's
belief that its existing RMR generation solutions are economically sound.
TEP is not required to purchase any power through this process that it
deems to be uneconomical, unreasonable or unreliable. The Track B bidding
process involved the ACC Staff and an independent monitor. The Track B Order
also confirmed that it is not intended to change the current retail rates for
generation services.
TEP entered into two agreements to meet its 2003 bid requirements
under the Track B Order for the period 2003 through 2006 as listed below:
o PPL Energy Plus, LLC contract for 37 MW from June 2003 through December
2003 and 75 MW from January 2004 through December 2006, under a unit
contingent contract.
o Panda Gila River generating station will supply 50 MW on-peak for the
June through September time period, from 2003 (which has been supplied)
through 2005, under a unit contingent contract between TEP and Panda
Gila River, L.P.
o No RMR bids were received.
Recent Arizona Court of Appeals Decision
On January 27, 2004, the Arizona Court of Appeals issued a decision
that resolved challenges to the ACC's Retail Electric Competition Rules. The
Court determined that certain rules established by the ACC relating to the entry
of new competitive electric service providers into the market were invalid. The
ultimate impact on TEP's Settlement Agreement is not known. A Motion for
Reconsideration was filed by Arizona Electric Power Cooperative (AEPCO) and
Duncan Valley Electric Cooperative (Duncan Valley), and a separate Motion to
Reconsider was filed by Trico Electric Cooperative (Trico). A Motion for
Reconsideration is a prerequisite to filing an appeal. AEPCO generates and
transmits electricity for its members in Arizona and California. Duncan Valley
and Trico provide electric service to rural areas in Arizona.
See Note 4 of Notes to Consolidated Financial Statements - TEP
Regulatory Matters, for more information on TEP's Settlement Agreement.
FEDERAL
During 2000 and 2001, the FERC ordered hearings and issued several
orders to mitigate volatile energy prices in the western U.S. and to address the
energy emergency in California. During 2000, the FERC established certain soft
caps on prices for power sold to the CISO. In June 2001, the FERC adopted a
price mitigation plan applicable to certain wholesale power sales in the western
U.S. This plan, which had a price cap of $91.87 per MWh, was in effect until
October 31, 2002. The FERC adopted a price cap for the period thereafter of $250
per MWh.
Market Manipulation Investigations
On June 25, 2003, the FERC alleged that 60 energy companies, including
TEP, may have engaged in manipulative practices that disrupted western energy
markets in 2001 and 2000. On January 22, 2004, FERC granted a Motion to Dismiss
all charges against TEP.
K-13
See Item 7. - Management's Discussion and Analysis of Financial
Condition and Results of Operations, Tucson Electric Power Company, Factors
Affecting Results of Operations, Western Energy Markets, below, for a discussion
of various FERC proceedings, including refund hearings on power sold to
California in 2000 and 2001, which may impact TEP's results.
K-14