• operating results during 2008 compared with 2007, and 2007 compared with 2006,

• factors which affect our results and outlook,

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

• dividends, and

• critical accounting policies.

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, 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. UED developed and owns the Black Mountain Generating Station (BMGS), a gas turbine project in Northern Arizona that provides energy to UNS Electric through a five-year power sale agreement. Millennium has existing investments in unregulated businesses; however no new investments are planned at Millennium. We conduct our business in three primary business segments - TEP, UNS Gas and UNS Electric.
On March 31, 2006, Millennium sold its interest in Global Solar Energy, Inc. (Global Solar), its largest holding. At December 31, 2008, the investment in Millennium represented 1% of UniSource Energy's total assets.
UNISOURCE ENERGY CONSOLIDATED
OUTLOOK AND STRATEGIES
Our financial prospects and outlook for the next few years will be affected by many factors including: TEP's 2008 Rate Order that freezes base rates through 2012, the recent national and regional economic down turn, the 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;

• 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;

• 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; and

• 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.

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, the growth in number of customers in UniSource Energy's utility service territories averaged 2% per year for TEP, and 3% per year for UNS Gas and UNS Electric. During 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% during 2008. 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% per year during the next 18 months. We did not experience a material increase in uncollectible accounts at TEP, UNS Gas or UNS Electric in 2008.
To date, UniSource Energy and its subsidiaries 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 $201 million was unused as of February 25, 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.
The credit agreements of UniSource Energy and its subsidiaries contain certain financial covenants. In September 2008, as a result of higher than expected fuel and purchased power costs, UniSource Energy and TEP amended their credit agreements to provide more flexibility to meet the required leverage ratios. The leverage ratios are calculated as a ratio of total indebtedness to earnings before interest, taxes, depreciation and amortization. In February 2009, the leverage ratio in the Unisource Energy credit agreement was further amended to provide additional flexibility. Although fuel and purchase power expenses have decreased in recent months, current economic conditions could result in lower customer growth rates and lower sales and could impact our ability to comply with these covenants.
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 February 25, 2009, TEP, UNS Electric and UNS Gas did not have any material power or gas trading exposure to financially distressed counterparties. 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. 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.
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 December 31, 2008, the total value of the pension assets was approximately $135 million, compared with $193 million as of December 31, 2007. Our projected benefit obligation at December 31, 2008 and at December 31, 2007 was $230 million and $209 million, respectively. Due to the recent decline in the plan total asset value, 2009 funding requirements are expected to be $16 million, compared with the $10 million annual contribution that was funded in 2008.

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. The cost impact of legislation or regulation to address global climate change would depend on the specific legislation or regulation enacted and cannot be determined at this time. For further discussion of the possible impact of environmental matters on our business, see Item 1. Business -Environmental Matters and Item 1A. Risk Factors.
RESULTS OF OPERATIONS
Executive Overview
UniSource Energy recorded Income Before Discontinued Operations of $14 million in 2008, $58 million in 2007 and $69 million in 2006. Net income of $67 million in 2006 reflects a $2 million loss from discontinued operations. 2008 Compared with 2007
UniSource Energy recorded net income of $14 million in 2008 compared with net income of $58 million in 2007. The decrease in UniSource Energy's net income in 2008 is due primarily to higher costs at TEP and the impacts resulting from the 2008 TEP Rate Order. TEP incurred higher coal-related fuel expense; higher purchased power costs due partially to plant outages in the first and third quarters of 2008; and higher operations and maintenance (O&M) expense primarily due to generating plant maintenance.
Results in 2008 were also impacted by: a $54 million decrease in TRA amortization; the 2008 TEP Rate Order that included a credit to retail customers that decreased revenue by $58 million; and adjustments that reduced pre-tax expenses by $32 million related to the reapplication of FAS 71 to TEP's generating assets, resulting from the 2008 TEP Rate Order. See Tucson Electric Power Company, Results of Operations, below. 2007 Compared with 2006
The decrease in UniSource Energy's net income in 2007 is due primarily to higher fuel and purchased power costs. Coal-related fuel expense at TEP was higher due primarily to a new rail and coal contract for Sundt Unit 4 that took effect at the beginning of 2007. Hot summer weather and planned coal plant outages at TEP during the first quarter put upward pressure on gas-related fuel costs and purchased power costs. Other factors impacting UniSource Energy's net income in 2007 included higher TRA amortization expense at TEP and increased operations and maintenance costs. See Tucson Electric Power Company, Results of Operations, below.
On March 31, 2006, Millennium sold Global Solar for $16 million in cash and an option to purchase, under certain conditions, 5% to 10% of Global Solar in the future. In the first quarter of 2006, UniSource Energy recorded an after-tax loss of approximately $2 million related to the discontinued operations and disposal of Global Solar.
See Other Non-Reportable Segments, Results of Operations, Discontinued Operations - Global Solar,below.

CONTRIBUTION BY BUSINESS SEGMENT
The table below shows the contributions to our consolidated after-tax earnings
by our three business segments and Other net income (loss).

                                                    2008          2007      2006
                                                       -Millions of Dollars-
        TEP                                        $     4       $   53     $  67
        UNS Gas                                          8            4         4
        UNS Electric                                     4            5         5
        Other (1)                                       (2 )         (4 )      (7 )

        Income Before Discontinued Operations           14           58        69

        Discontinued Operations - Net of Tax (2)         -            -        (2 )

        Consolidated Net Income                    $    14       $   58     $  67

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

(2) Relates to the discontinued operations of Global Solar.

LIQUIDITY AND CAPITAL RESOURCES

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
Balances As of                                     Cash and Cash           under Revolving          under Revolving
February 25, 2009                                   Equivalents           Credit Facility(3)        Credit Facility
                                                                        -Millions of Dollars-
UniSource Energy stand-alone                      $             4        $                 42      $              28
TEP                                                            24                          11                    139
UNS Gas                                                         8                          10                     25 (1)
UNS Electric                                                    5                          16                     19 (1)
Other                                                           9 (2)                     N/A                    N/A

Total                                             $            50

(1) Currently, 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.

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

(3) Includes LOCs issued under Revolving Credit Facilities

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 December 31, 2008, UniSource Energy's short-term investments include highly-rated and liquid money market funds and commercial paper. 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 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 7A. Qualitative and Quantitative Disclosures about Market Risk, Credit Risk, below. 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.
Executive Overview - UniSource Energy Consolidated Cash Flows

2008 2007 2006 -Millions of Dollars- Cash provided by (used in):

               Operating Activities          $    277     $  323     $  283
               Investing Activities              (453 )     (217 )     (246 )
               Financing Activities               141       (119 )      (77 )

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. As a result of the varied seasonal cash flow, UniSource Energy, TEP, UNS Gas and UNS Electric use, as needed, their revolving credit facilities to fund their business activities.
Cash used for investing activities is primarily a result of capital expenditures at TEP, UNS Gas and UNS Electric. Cash used for investing and financing activities can fluctuate year-to-year depending on: capital expenditures, 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.
Operating Activities
In 2008, net cash flows from operating activities were $46 million lower than the same period in 2007. The decrease was due primarily to payments for increased fuel and purchased power costs and operations and maintenance activities, and lower proceeds from the sale of SO2 emissions allowances, partially offset by income tax refunds, higher wholesale sales receipts, lower income taxes paid and lower interest paid in 2008. Investing Activities
Net cash used for investing activities was $236 million higher in 2008 compared with 2007 due to a $133 million deposit made with the trustee of maturing bonds at TEP and an increase in capital expenditures. In 2008, TEP had long-term debt maturities of $138 million which it retired with proceeds from the redemption of $221 million of IDBs that TEP held for its own account. Funding for this redemption was provided by the issuance of new IDBs in March and June 2008. The deposit was applied by the trustee to TEP's bonds that matured on August 1, 2008. Capital expenditures were $104 million higher in 2008 due primarily to environmental upgrades to the San Juan generating station, transmission system improvements and the completion of BMGS.

Capital Expenditures

                                       Actual                        Estimated
      Business Segment                  2008       2009      2010      2011      2012      2013
                                                               -Millions of Dollars-
      TEP                             $    287     $ 245     $ 227     $ 257     $ 222     $ 188
      UNS Gas                               16        20        19        21        22        23
      UNS Electric                          30        29        24        23        37        16
      UED                                   16         -         -         -         -         -

      UniSource Energy Consolidated   $    349     $ 294     $ 270     $ 301     $ 281     $ 227

UniSource Energy's capital expenditures of $349 million in 2008 were $44 million below the estimate provided in our 2007 Form 10-K due primarily to lower than expected customer growth and usage, as well as lower material costs. UniSource Energy's forecasted consolidated capital expenditures for 2009 and 2010 are approximately $87 million, or 13% below the estimates provided in our 2007 Form 10-K, as we expect the economic slow down to impact customer growth and material costs in all of our utility service territories. In addition, the ACC is expected to require TEP and UNS Electric to charge customers for the total cost of line extensions, eliminating the prior practice of providing a portion of line extensions free of charge to customers. TEP's estimates exclude capital expenditures related to the proposed transmission line to Nogales, Arizona, while they include the purchase of Sundt Unit 4 in 2011. For more information see, TEP, Liquidity and Capital Resources, Investing Activities, Forecasted Capital Expenditures, below, and Item 1. Business, TEP, Transmission Access, Tucson to Nogales Transmission Line, above. Financing Activities
Net cash flows from financing activities were $260 million higher in 2008 compared with 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: UNS Electric's repayment of $60 million of notes that matured in August 2008 and outstanding borrowings under the UNS Gas/UNS Electric Revolver, higher payments on capital lease obligations by TEP and common stock dividends paid by UniSource Energy.
Capital Contributions
In December 2008, UniSource Energy contributed $59 million in capital to UED by canceling an intercompany promissory note in the amount of $59 million. Borrowings under the promissory note were used to finance the development of BMGS.
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 August 2011. Principal payments of $1.5 million on the outstanding term loan are due quarterly, with the balance due at maturity. At December 31, 2008, there was $15 million outstanding under the term loan facility and $43 million outstanding under the UniSource Energy revolving credit facility at a weighted average interest rate of 2.48%. We have the option of paying interest on the term loan and on borrowings under the revolving credit facility at adjusted LIBOR plus 1.25% or the sum of the greater of the federal funds rate plus 0.5% or the agent bank's reference rate and 0.25%.
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. We may pay dividends if, after giving effect to the dividend payment, we have more than $15 million of unrestricted cash and unused revolving credit. In September 2008, as a result of higher than expected fuel and purchased power costs, UniSource Energy its credit agreements to provide more flexibility to meet the required leverage ratio. Although fuel and purchase power expenses have decreased in recent months, current economic conditions could result in lower customer growth rates and lower sales. If our financial results are impacted by the economic downturn, our ability to comply with financial covenants could be jeopardized and we may seek waivers or amendments of the covenants. In February 2009, the leverage ratio in the UniSource Energy credit agreement was further amended to provide additional flexibility. Although fuel and purchase power expenses have decreased in recent months, current economic conditions could result in lower customer growth rates and lower sales and could impact our ability to comply with these covenants.

As of December 31, 2008, we were in compliance with the terms of the UniSource Credit Agreement.
If an event of default occurs, the UniSource Credit Agreement may become immediately due and payable. An event of default includes failure to make required payments under the UniSource Credit Agreement, failure of UniSource Energy or certain subsidiaries to make payments or default on debt greater than $20 million, or certain bankruptcy events at UniSource Energy or certain subsidiaries.
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 LIBOR and other benchmark interest rates, UniSource Energy may be required to pay higher rates of interest on borrowings under its revolving credit facility. See Item 7A. 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 27.033 shares of our Common Stock at any time, representing a conversion price of approximately $36.99 per share of our Common Stock, subject to adjustments. The closing price of UniSource Energy's Common Stock was $23.57 on February 25, 2009.
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 at December 31, 2008 were:
• 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 . . .