JONES DAY TALKS®: Real Assets Roundup Episode 4: Legal and Energy Challenges of Powering Data Centers

Dave Dalton:

We hope you've enjoyed the previous episode of Jones Day's Real Assets Roundup here at JONES DAY TALKS®. If you haven't heard them, check the link we've provided, and be sure to subscribe to receive future episodes in your mailbox as they're released.

In today's program. Brian Sedlak and his panel talk about energy and utility issues facing the data center industry. And he's on the road in Houston, Texas for this program, so we're better to hear about anything energy related. Stay here, lots of good insights are on the way. I'm Dave Dalton. You're listening to JONES DAY TALKS®.

Brian Sedlak:

Welcome to the Real Assets Roundup, what I believe is the world's most popular legal-focused real assets podcast in the world. I'm Brian Sedlak, host of The Roundup, and I'm a real assets lawyer from Jones Day in Chicago.

Today, we wanted to focus on energy and utility issues facing the data center industry. We are in Houston for an energy and infrastructure forum. I want to say it's beautiful here. I have to apologize to Kit Rockhill who is our host. I had thought it was going to be a little too humid in Houston.

Some of you may remember Kit from episode one, where I think some of the audience referred to Kit as the pumpkin lady. I think that's how she's known from this day forward.

But today, I'm joined by Melissa Vandewater from Chicago, Jeff Schlegel from here in Houston, and Paul Jones who made it all the way from London. Guys, why don't you introduce yourself? Melissa, I think you are our first repeat guest on The Roundup, so why don't you go first?

Melissa Vandewater:

Yes. From Columbus to Houston. And I flew this morning from Chicago with Brian, so happy to be here. Melissa Vandewater, I'm a partner in the real estate group in Chicago. I have been practicing real estate law for over 20 years, and I have a focus on data center development and leasing, and looking forward to talking about energy today.

Brian Sedlak:

Jeff, since this is your hometown, why don't you tell us a little bit about yourself?

Jeff Schlegel:

Well, it's not my hometown, Brian. I'm actually from New Jersey.

Brian Sedlak:

No kidding?

Jeff Schlegel:

Yep, but I've been here-

Brian Sedlak:

It makes a lot of sense.

Jeff Schlegel:

I've been here for almost 36 years. I'm Jeff Schlegel. I head Jones Day's energy practice, doing traditional hydrocarbons, energy transition, chemicals, and infrastructure development.

I've been practicing for 35 of the 36 years I've been in Houston, and frankly, Houston is a paradise. Global warming affects every place in a different way and I think it's just moderating the climate in Houston, so glad you can enjoy it.

Brian Sedlak:

Good. So Houston's a winner. All right. Paul Jones all the way from London. Why don't you introduce yourself?

Paul Jones:

Of course. Thank you, Brian. Thank you to Jeff and Kit for hosting as well. So I'm Paul Jones, I'm a partner in the energy practice in the London office at Jones Day. So I'm a career energy lawyer working across the value chain, increasingly working these days in the real asset space.

So my career, like a loss of energy lawyers, has followed the sector. So starting off mainly doing oil and gas, then increasing amounts of renewables, low carbon molecules, and now lots of digital infrastructure as well. So great to be here. I used to live in Dubai, so the humidity, as it hit me when I left the airport, reminded me very much of those days, so enjoying being here.

Brian Sedlak:

That's great. Melissa, why don't we start with you? Can you set the table for us in terms of energy and utility challenges facing the data center industry today?

Melissa Vandewater:

Absolutely. So as everyone knows, power is really to the core of a data center project. Site selection of these projects is really driven where the power is. There's other factors, but power really is primary. As we know, we're in an AI boom, cloud migration and demand for data. Our reliance on data centers to house equipment that generates our day-to-day life is really driven by power, and there is such an increase in demand.

Now, one of the key challenges is just trying to find solutions to infrastructure constraints, now, power infrastructure constraints, given the huge amount of power demands. So now, we see a lot of creativity and innovation in this space, trying to solve potential on site, behind the meter type developments, which we'll get into a little bit later, but really now it's the push full of supply and demand. Demand is exceeding current availability, and that's the key issue and sort of headwind in this industry.

Brian Sedlak:

Jeff, why don't we drill down on this a little further, so to speak? Can you walk us through the issues in a little more detail?

Jeff Schlegel:

Yeah, sure. Melissa is exactly right. Access to power is one of the key considerations, and we are in a situation in this country without really any clear energy policy for a long time, where demand and supply have been relatively balanced, but with some challenges. And with the addition of so much demand in such short amount of time, meeting that demand has been a real issue.

People don't know how much we rely on renewables in this country. 17% of all power generated last year came from renewable energy. 95% of all new demand was met by renewable energy. So, you've faced the challenges of access to the traditional grid, the ability of the grid to meet that demand, the amount of infrastructure that needs to be built in traditional power generation to meet that demand, and the growth of renewables to meet the demand in the meantime.

I think now particularly where the renewable energy industry in the US has hit some significant hurdles with the new administration, it's created even more challenges. Most of these projects require a fair bit of time to get in place. They require significant investment, they require coordination among many interested parties, governmental and non-governmental. And so, it just increases the difficulty of finding the right place with the right amount of energy, the right mix of energy from a cost perspective, and the right amount of reliability in order to make these projects work.

Brian Sedlak:

Yeah, and the statistics are really mind-boggling. I was doing a little research for this episode and I saw that ERCOT's CEO had said that data centers and crypto mining could account for two thirds of Texas's doubling energy demand by 2030.

Jeff Schlegel:

That's right.

Brian Sedlak:

I think it's just staggering. Or the Electric Power Research Institute said that data centers could consume 9%, some people have said 12% of total US electricity by 2028. Those numbers are staggering.

Jeff Schlegel:

The numbers are staggering and the cost of traditional generation is going up. And so, that's been part of the debate about the use of renewable energy to power, at least in part data centers, is that the levelized cost for renewable energy has continued to come down through efficiencies, technological efficiencies and other reasons, supply chain efficiencies to rival that of traditional power generation.

And so, it makes it more difficult when you have such resistance from the federal government to the development of renewable energy. Texas is a great example. It's one of the places where you've got the most opportunity for data center development. You've got cheap land, you've got access to power, but there needs to be more power in order to do it.

The federal government's, the impediments that are now in place, really apply to projects on federal land, but there's almost no part of a data center project that doesn't touch some federal aspect. And the current administration has made it very clear that where it does touch the federal government, they're going to be in the way in order to promote the development of hydrocarbon-based fuels for power generation.

Brian Sedlak:

Thanks for that, Jeff. Of course, Jones Day is an international law firm and we've been chatting a little bit about the US so far, primarily. One day we'll have the Paul Greening on the podcast and he can tell us about APAC. But right now, we have Paul Jones. So Paul, why don't you talk to us a little bit about maybe what the situation is in the UK and Europe, and maybe how it compares to the US and what's happening over there?

Paul Jones:

Certainly, Brian. A lot of the challenges and the bottlenecks that you've referred to stateside are very familiar across the pond as well. So in Europe, we obviously have a Europe-wide regulatory system, and then we have nationwide individual regulations that different countries are adopting, and you've got a real difference of approach taken in different jurisdictions.

So in certain jurisdictions, in the UK for instance at the moment, we're going through a once-in-a-generation overhaul of the entire grid, which is geared up towards ensuring that we can fulfill various climate commitments primarily. But obviously, this is happening at the same time as there's a whole load of new data centers requiring a significant amount of additional energy demand to be provided.

So you've got a where the grid operator and the grid companies are having to engage with the regulators and with governments to try and strategically prioritize certain projects to ensure that we can meet demand, and at the same time, deliver on all of the other grid connections that are required.

We're seeing in certain jurisdictions, like Ireland for instance, there already seems to have reached a tipping point where there's effectively a moratorium at the moment on new grid connections for data centers. In the Netherlands, there's quotas for new connections, and then Germany is slightly similar to the UK at the moment in working closely between regulators and grid operators to try and deliver all of the upgrades that are needed.

So there's a real push and pull, really, within the regulations, because in one respect you've got people trying to prioritize data centers. And then on the other side, from a regulatory perspective, there's an awful lot of increased focus on data centers. So looking at increasing the levels of technology that are used within data centers, which might require some retrofitting if data centers don't already have those as part of their power solutions.

So from a diligence perspective, if you're an investor or a lender, you're having to scrutinize not just looking at the basic grid connection, but also thinking about whether or not this is future-proofed, and whether in 10 or 15 years there's going to be sufficient power coming through the cables.

Jeff Schlegel:

It's interesting, 'cause we have a corollary in the US to your jurisdictional discussion, which is we all focus on the federal government and its role, but the state governments in the United States have a very significant role in how they promote types of power to be produced and their willingness to be homes to data centers.

Nevada just had a big pushback on a very large data center project based on access to water. New York is talking about potentially moving out its targets for meeting net-zero goals and other renewable goals because they don't think it's realistic that they can make it.

So different states have different views. Same way in the EU, different jurisdictions have different views, different regulatory schemes, which may or may not conflict with the EU's approach. We have the same issue here.

There's a lot of forum shopping going on in trying to figure out which jurisdictions from a state perspective might provide shelter from the headwinds of the federal government, and which of those jurisdictions also have the resources to support this kind of development.

Brian Sedlak:

Yeah, I saw something the other day that it might take something like five to seven years to get a natural gas plant permitted, and I know the federal government's trying to speed that up a little bit, but that's a long pull in the tent, so to speak.

Jeff Schlegel:

It is, and then there's gas procurement issues and gas transportation issues. You can't just build a power plant, you have to have a source of supply, whether it's coal or natural gas, and more likely natural gas. But the federal government's pushing coal as well, where you're not procuring the sun and you're not procuring the wind.

And obviously, there are issues with renewable sources of supply from a reliability standpoint and all that, but the overall development cycle is less, and the environmental impact potentially is less than trying to build from the ground up a baseload natural gas power plant.

Brian Sedlak:

And this is a question from Melissa or for you, Jeff, again, in terms of these large hyperscale data centers, is there a particular party, either the owner or the hyperscaler, that is committing to the off take of power for, let's say, a long-term period of time? The period at least that's necessary to recoup some of possibly the capital costs or possible stranded costs? Who is signing up to take on that obligation that the utilities maybe can get a little more comfortable with the investment so the public isn't stuck with it?

Melissa Vandewater:

Well, we definitely see both the developer and operator that side of the house taking those direct obligations on through direct agreements like electric service agreements with the utilities directly. But we also see hyperscalers signing up for that, whether it's a behind-the-meter type PPA arrangement or whether they're signing directly onto those ESAs with the utility.

What we see now, given these large load projects, these utilities are wanting to make sure they have real data center projects. So they're actually including in a lot of new tariffs and requirements, financial security obligations that really can only be satisfied by your hyperscalers.

So you do see a combination of both. Certainly, when the operator is signing up to those obligations directly, they seek to pass through not only the economic requirements, but also those financial security requirements to the hyperscalers.

So ultimately, the hyperscalers bear the burden, but certainly there's a push-pull in negotiating those documents with customers like hyperscalers in terms of who's bearing the risk, not only in signing those agreements, but also the delivery by the utility under those agreements, whether it's the construction of generation facilities, transmission, securing of easements and access rights for the transmission lines, or the delivery of the supply of capacity.

All of that has significant risk to the data center project, ultimately the investors in that operator and the hyperscalers themselves. So we oftentimes spend a lot of time negotiating late delivery penalties, potential force majeure relief on the front end of a development.

And on the back end, certainly in operational requirements, service level requirements, and for your delivery of uninterrupted power 24-7, and you see a lot of liquidated damages concerns and negotiation around potential exclusions for possible force majeure or our utility delay for that.

Brian Sedlak:

Yeah, and let's unpack that just for a second. Is a little bit of what's going on here, when you give the statistics in terms of the demand and then you talk to some consultants in the community, are they saying really what's going on here is what I'll call option buying?

That maybe now going forward, this is not happening because facilities are taking a harder look at it, but was what was going on people were trying to reserve a place in the queue, so they were saying, a lot of users, potential users, operators, owners were saying, "I'm going to need this demand in five years"? Where really they didn't. It was speculative.

And so they're in essence clogging the queue. So, is a little bit what you're saying, the utilities are trying to vet that by requiring real dollars so that folks are serious and not option buying? You think that's a fair assessment?

Melissa Vandewater:

Absolutely. They have to honor the queue. If you're first in line, they want to know you're really going to get the deal done 'cause an investment in time and money. And also, just PR, public announcements of projects, a particular location may only be really valuable for a very brief amount of time.

So it's prime time, it's time to invest. They want to make sure they're working with a party who's financially capable, who has the relationships to what they're advertising. Is it a real project to get it done within the timetables required of the utility as well?

Jeff Schlegel:

There's a whole lot of interdependencies in these projects. I mean significant interdependencies, that if it's not managed correctly, it could blow it all up. And so it is a huge risk for the hyperscalers and the operators, but also for the utilities. And they're trying to manage that risk in a gold rush environment.

And it's not unique to data centers. We've seen it over and over in all sorts of energy industry investments where you want to be first in line to do it, even if you don't necessarily have the backing or the technical expertise or 1 of 100 things you need in order to make one of these projects successful.

So, managing that from the utility standpoint, no one's usually altogether that sympathetic to utilities, but they're in a very difficult position. They have to make significant investments, and those investments have to be backed by other significant investments, and on and on and on and on. So it's a real commitment by all the parties in order to try and make it happen, let alone actually make it happen.

Brian Sedlak:

Well, Paul, let's pick on you for a second. When some of our clients come over from Europe, they say, "Well, it's just very difficult here in the US. You've got a federal government, you've got at least 50 separate jurisdictions to deal with." But what about Europe for which these purposes also include the UK, which may be you being from the UK, don't want that definition, but-

Paul Jones:

It's very contentious topic.

Brian Sedlak:

I've heard. I've heard. I don't want to start an incident, but in terms of regulation, if you're coming into continental Europe as a data center owner, what are you looking at from a regulatory perspective? Is it very different if you're citing in Spain or Italy or Germany, or is it basically it's uniform, it's the EU, and so it's all the same?

Paul Jones:

It's definitely not uniform, so you do have to take it on a jurisdiction by jurisdiction basis. Certainly, the UK because of Brexit has an entirely separate system, but it's aligned in a lot of ways with the system that's adopted in Europe. But from a policy perspective, definitely individual governments have different views, and then there's so many other factors influencing where data centers are developed as well.

And then the grid has developed differently in different countries. So you would've seen in Spain and Portugal, for instance, earlier this year, the whole grid dropped for half a day or so, and that triggered a huge inquiry into what happened. I think still nobody's really got to the bottom of the actual cause of that, but it certainly placed a lot of focus on the strength of the grid in that part of Europe. And it's really reframed the way people are thinking about it.

So in the UK for instance, the issue you're talking about, which we call zombie projects in the UK, the main focus of our connections reform process has been to move from a first-in-line to a first-ready, first-connected process. So there will be new criteria and new entry points of a project. So it means that data centers in the UK are likely to be strategically prioritized, and there will be processes in place to deal with that.

And then also, there are regulations around how data centers can monetize their power assets as well. So we have the capacity markets, for instance, which apply in Europe, and then also specifically in the UK where data centers can become, I presume, as I've seen the term used, where they're both producers and consumers of energy. And obviously, that's a separate business model that can be monetized by data center developers. In the UK for instance, we now have, as part of the New Energy Act, data centers can participate in capacity market auctions, which creates a new revenue stream for the developer.

Brian Sedlak:

Well, let's just flip back to Jeff. That was very interesting in terms of Europe, but let's talk about potential solutions. What have you seen or tried to structure in terms of trying to make the provision of utilities to a data center allocate the risks properly between the parties? And Melissa, you can jump in here too, 'cause I know you've been involved.

Jeff Schlegel:

Yeah, I was going to say, Melissa has already hit on this to some extent. There is a very deliberate allocation of risk among all of the parties that are involved. The utilities aren't going to take much risk, but between the developer and the hyperscaler, who is going to bear the risk of delays? Who's going to bear the risk of service-level interruptions?

There's just 100 risks in these agreements that have to be properly allocated, and every major participant has their own view of risks that they're willing to accept. So it is somewhat bespoke in that sense, and I also think it is evolving significantly, the willingness to take risks because the upside is increasingly good, you see that reflected in it.

But in the end, someone has to stand behind it. And it's difficult. It's the confluence of technology and power, both of which have their issues. I've been building computers myself since I was in high school and I upgrade constantly. And the same thing happens with data centers. So you're finding ways to be more efficient, you're finding more efficient ways to consume power, more efficient ways to cool, more efficient ways to access data, more efficient ways to transmit data. All these things affect the life of a project.

And so trying to allocate these liabilities before it's even started, yeah, of course you can do it, but you may not be right. Like any other kind of infrastructure project, you use your crystal ball to figure out what things might happen in the future, but things move so quickly in this industry, you're going to make mistakes. And so, trying to build in both certainty and flexibility is really the key. It's hard to do.

Because this has become such a thing around the world, but in the US and our experience, you're getting more and more sophisticated lawyers, advisors, commercial parties who are being more and more creative about how they handle these risks. And identifying risks that maybe they didn't see in the first project, but they now see in the second and maybe a third project. And you're projecting out, as Melissa said, it could be seven years before from the, "Hey, let's do this," to the flipping the switch, and things are going to change. So, that kind of creativity and flexibility is sort of fun to be in the middle of.

Brian Sedlak:

And so, you're saying it's not as simple as Melissa and I building a nuclear reactor next to our data center. Is that what I take?

Jeff Schlegel:

I think that is a great idea. And actually, it is. I know you're joking, but we have to be more open-minded in terms of the sources of supply of power, and whether the behind the meter or otherwise. I just read an article about the Denver airport, which was going to fund a feasibility study to use small modular nuclear reactors to power their needs. And that's an airport that is continuing to expand and it's going to be significantly bigger in 10 years.

And they did so without maybe running it by all the constituents in the area, and they went nuts appropriately. They want to be consulted. And it's like when we did LNG projects in the US, import projects, people had this view of LNG and port terminals exploding, and fire on the water and all that. And a lot of it went down to just not really bringing in all the potential participants, the community, and talking it through so they understand the real risks and the real opportunities.

Brian Sedlak:

Well, when Melissa and I build our reactor, it's not going to be a small modular reactor. It's going to be one with big cooling towers and stuff. That's what we're doing.

Jeff Schlegel:

Perfect.

Brian Sedlak:

You okay with that, Melissa?

Melissa Vandewater:

I'm good with that.

Brian Sedlak:

Yeah, but that's what I was trying to tease. I was trying to tease out really some of the behind the meter solutions, so thanks for touching on that. So Melissa, at the end of the day, is everyone just headed to Pennsylvania, so to speak? Is everyone headed to South Dakota? Is it really it's now, because of the concentration of population and the demands on energy, that really need to constantly look for the new frontier? And it seems like the new frontier is now approaching Pennsylvania. You think that's fair?

Melissa Vandewater:

Pennsylvania is very attractive for data center projects and developments. They really checks all the boxes in terms of just land availability, in terms of energy resources, access to energy through gas and natural gas and hydro. There's skilled labor force with the various universities, skilled workers there ready to work on these data center projects. I think, too, the location. Being near the northeast and the northeast region, I think is also attractive.

And I think probably if that weren't enough, you see actual dollars being invested. Currently, we see upwards of $90 billion of commitments from different investors. I think Blackstone committed 25 billion to actually build out the energy infrastructure on Pennsylvania. So those very compelling case for projects in Pennsylvania in particular.

Jeff Schlegel:

And it highlights the role of the states. States are actively competing for these projects. And when we talk about the federal versus state issues, whether the federal government is in favor of it or not, these projects create jobs, they create taxes and opportunities, and for a whole lot of different participants.

So, the states are looking for ways to maybe couch their support for these projects in a way that is more palatable than, "We're doing this because of AI and we're using renewables, for example, to combat climate change." They're saying, "No, we're using these because it creates jobs, it creates opportunities. It's going to enrich our state," whether you're a blue state or a red state.

Now, the problem with any state is that the politics can flip, the regulatory priorities can flip every couple of years, but Pennsylvania is absolutely a jurisdiction I think that learned in part from its role in the shale revolution, that finding a way to appropriately regulate, but also being pro-development can be a win-win situation.

Brian Sedlak:

Well, if any state can figure it out, I think it's Pennsylvania. Obviously, as you said, they were at the heart of the petroleum and coal portions of our industrial cycle, so I think they'll be able to figure it out. So, maybe that's a good place to stop. Energy is one of the biggest issues that's going to impact the data center industry. It is the fourth utility now.

I do want somebody to have a survey with various age groups and list the four now utilities, electricity, gas, water, and data, and ask people to rank them, like, "If you had to cut one of these, which one would it be?" And then get down to the last one.

I think for a lot of folks, particularly at a younger age, you may find that they are viewing data as important as anything else, if not more important, which I think will be interesting.

So, stay tuned to see how these problems are going to be solved. I think we are going to plan a data center summit in Pennsylvania at some point in November, but we're next headed to London for a data center master class in September. So Paul, we look forward to you hosting us there, along with episode one guest, Vica Irani.

I will say that this podcast, The Roundup, is sponsored by Jones Day. And if you are a second through fifth year associate with real assets experience and you would like to talk to us about real assets, why don't you send an email to the realassetsroundup@jonesday.com. We have our own email address online at this point.

Or if you have a topic that you would like us to discuss on a future episode, please send those comments as well. And if you'd like to say anything about Jeff's dulcet tones, I'm sure he would like to hear that as well.

Jeff Schlegel:

Absolutely.

Brian Sedlak:

So thank you. It was a great conversation. I know we went a little longer than we normally do. For more information, please visit jonesday.com, and remember to subscribe to get advanced access to each episode of the Real Assets Roundup and special subscribers only content. So this wraps up episode four of the Real Assets Roundup. I'm Brian Sedlak. Until next time, enjoy the summer.

Dave Dalton:

Thank you, Brian. You can find complete bios for Brian Sedlak, Paul Jones, Melissa Vandewater, and Jeff Schlegel at jonesday.com. Check out our insights page while you're there for more podcasts, videos, and publications on topics where you'd like more information.

Subscribe to JONES DAY TALKS® at Apple Podcasts, or wherever else you find your quality business related podcast. JONES DAY TALKS® was produced flawlessly by Tom Kondilas. As always, we thank you for listening. I'm Dave Dalton. We'll talk to you next time.

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