Summary of UNISOURCE ENERGY CORP

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, 2009 compared with the same periods in 2008;

• 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 2008 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, 2009 and 2008. 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), UniSource Energy Development Company (UED) and Millennium Energy Holdings, Inc. (Millennium).
TEP, an electric utility, provides electric service to the community of Tucson, Arizona. 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. UED developed and owns the Black Mountain Generating Station (BMGS), a 90 MW natural gas-fired peaking facility in Northern Arizona that, through a power sales agreement, is providing energy to UNS Electric. Millennium has existing investments in unregulated businesses; however no new investments are planned at Millennium. At September 30, 2009, the investment in Millennium represented 1% of UniSource Energy's total assets. We conduct our business in three primary business segments - TEP, UNS Gas and UNS Electric.
OUTLOOK AND STRATEGIES
Our financial prospects and outlook for the next few years will be affected by many factors including: the 2008 TEP Rate Order that freezes base rates through 2012, the recent national and regional economic downturn, potential financial market disruptions and volatility, potential regulations impacting greenhouse gas emissions and other regulatory factors. Our plans and strategies include the following:
• Maintain and enhance TEP's system reliability and safety while operating under a base rate freeze through 2012;

• Maintain an appropriate cost structure while operating under a base rate freeze through 2012;

• 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;

• Expand TEP and UNS Electric's portfolio of renewable energy sources and demand side management programs to meet Arizona's renewable energy standards;

Table of Contents

• 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;

• Obtain ACC approval of rate increases for UNS Gas and UNS Electric to provide adequate revenues to cover the rising cost of providing reliable and safe service to their customers; and

• Develop strategic responses to potential new legislation on carbon emissions and define steps to achieve environmental objectives that provide an appropriate return on investment and are consistent with earnings growth.

Economic Conditions
As a result of general economic conditions, retail customer growth and energy sales to all classes of customers at UniSource Energy's utility subsidiaries are below the average levels experienced in prior periods. UniSource Energy's future results of operations may continue to be impacted by weak economic conditions. While we cannot predict if the rate of growth in number of customers will return to historic levels, we expect combined customer growth rate to average 1% or less per year during the next 18 months. Despite the weak economic conditions, we did not experience a material increase in uncollectible accounts at TEP, UNS Gas or UNS Electric in the last 12 months.
To date, UniSource Energy and its subsidiaries' liquidity have not been materially impacted by volatility and disruptions 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 $204 million was unused as of October 28, 2009, 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.
As of October 28, 2009, TEP, UNS Electric and UNS Gas did not have any material power or gas trading exposure to financially distressed counterparties. TEP, UNS Gas and UNS Electric maintain noncontributory, defined benefit pension plans for substantially all regular employees and certain affiliate employees. 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 September 30, 2009, the total value of the pension assets was approximately $175 million, compared with $135 million as of December 31, 2008. Our projected benefit obligation at December 31, 2008 was $230 million. Due to the decline in the total asset value of the plans during 2008, UniSource Energy made pension plan contributions of $20 million during the first nine months of 2009; additional contributions may be made during the fourth quarter of 2009. In 2008, UniSource Energy made pension plan contributions of $10 million. 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. For a further discussion of economic conditions and their impact on UniSource Energy, see Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Result of Operations, UniSource Energy Consolidated -Economic Conditions in UniSource Energy and TEP's 2008 Annual Report on Form 10-K. Environmental Matters
UniSource Energy's utility subsidiaries are subject to numerous federal, state and local environmental laws and regulations affecting present and future operations, including regulations regarding air emissions, water quality, wastewater discharges, solid waste and hazardous waste.
These laws and regulations can result in increased capital, operating and other costs, particularly with regard to enforcement efforts focused on existing power plants and compliance plans with regard to new and existing power plants. There are proposals and ongoing studies at the state, federal and international levels to address global climate change that could result in the regulation of CO2 and other greenhouse gases. There are federal strategic initiatives underway addressing renewable energy and energy efficiency standards. The cost impact of legislation or regulation to address these initiatives depends on the specific legislation or regulation enacted and cannot be determined at this time although such costs could be substantial due to TEP's use of coal as the primary fuel for generation. We would seek rate relief in the event of the imposition of a federal carbon tax or related federal carbon regulations.

Table of Contents

RESULTS OF OPERATIONS
Executive Overview
2009 compared with 2008
We expect UniSource Energy's net income and results from operations to improve in 2009 compared with 2008 due primarily to the following reasons:
• A 6% base rate increase that was effective December 1, 2008 for TEP's customers and the implementation of a purchased power and fuel adjustment clause (PPFAC) at TEP beginning January 1, 2009. The base rate increase should generate approximately $50 million of additional revenue based on 2008 retail kWh sales levels, while the PPFAC allows TEP to pass through the actual cost of fuel and purchased power costs to retail customers. Through the first nine months of 2009, TEP's retail kWh sales were 1.0% below kWh sales levels during the same period of 2008. As a result of the PPFAC, relative to prior periods, TEP's net income should not be as sensitive to changes in fuel and purchased power costs or revenues from short-term wholesale sales which are an off-set to the recoverable PPFAC costs;

• No amortization expense related to TEP's Transition Recovery Asset (TRA) will be recorded in 2009 since that asset became fully amortized in May 2008. In 2008, TEP recorded TRA amortization of $24 million; and

• TEP will not defer recognition of any revenues subject to refund during 2009. During 2008, TEP deferred $58 million of revenue to be refunded.

These factors will be partially offset by:
• Higher operating costs due to increases in general O&M costs, pension-related expenses and planned generating plant maintenance; and

• An increase in depreciation and amortization expense caused by an increase in plant in service, and the effects of the 2008 TEP Rate Order that increased depreciation rates on certain assets and amortization expense related to certain regulatory assets.

Seasonality of Utility Operations
The net income and results of operations of UniSource Energy's utility businesses are seasonal in nature. TEP and UNS Electric are summer-peaking utilities and historically have recorded a majority of their net income during the second and third quarters, when hot weather drives increases in energy consumption. Energy demand from UNS Gas customers typically peaks during the winter, and that company records the majority of its net income during the first and fourth quarters.
TEP's new rates, which include higher charges for higher levels of energy use, are expected to shift an even greater share of our earnings to summer peak periods. Moreover, our earnings will no longer benefit from the sale of excess energy during periods of lower consumption, including the first and fourth quarters, since that wholesale revenue is now credited against charges included in the new PPFAC.

Table of Contents

Third Quarter of 2009 Compared with the Third Quarter of 2008 UniSource Energy reported net income of $58 million in the third quarter of 2009 compared with a net loss of $11 million in the third quarter of 2008. The increase in UniSource Energy's net income in the third quarter of 2009 is due primarily to a $67 million increase in net income at TEP. The increase in TEP's net income resulted from: hot summer weather; lower fuel and purchased power expense resulting from a decrease in the wholesale market price for natural gas and energy; a $30 million provision for rate refunds that was recorded in 2008; new retail rates; and operating cost controls. See Tucson Electric Power Company, Results of Operations, below.
Nine Months Ended September 30, 2009 Compared with the Nine Months Ended September 30, 2008
UniSource Energy reported net income of $94 million for the first nine months of 2009 compared with a net loss of $9 million in the same period last year. The increase in UniSource Energy's net income in the first nine months of 2009 is due primarily to: an increase in TEP's retail revenues resulting from the base rate increase and hot summer weather during the third quarter of 2009; lower fuel and purchased power expense; no provision for rate refunds recorded by TEP in the first nine months of 2009 compared with $44 million in the same period last year; no TRA amortization expense recorded by TEP in the first nine months of 2009 compared with $24 million in the same period last year; and a $6 million pre-tax gain related to the sale of an investment by Millennium recorded in the second quarter of 2009. See Tucson Electric Power Company, and Other Non-Reportable Business Segments, Results of Operations, below.