Navigating State-Level Cost Allocation Shifts: Strategies for Data Center Developers

Across the U.S., laws and regulatory policies are being adopted that significantly impact the economics of data center development.

These measures include upfront interconnection application fees and new tariffs for large data center loads, as well as special contracts with take-or-pay minimums, early termination fees and longer mandatory contract terms, all of which aim to shield captive residential and small-business customers from stranded-cost risks.

In parallel, communities are pressing for transparency on water use, diesel back-up generation, and noise and air pollution abatement — social headwinds that reinforce regulators' push to ring-fence costs to the primary beneficiaries of new grid build-outs. Amid the rising costs and enhanced risk profile that these changes bring, developers face mounting challenges to maintain project bankability.

Emerging Legal Frameworks Affecting Data Centers

In recent years, state utility commissions have begun exploring ways to ensure costs associated with serving unique large-load customers, such as data center developers, are fairly allocated in an effort to alleviate concerns that these costs will be directly or indirectly borne by captive ratepayers.

Social pressures are also imposing strain in other areas of data center development, with communities challenging projects over the extensive amount of land these projects require, water consumption and impacts on the environment and available local resources, over-reliance on diesel back-up generation and the resultant air pollution issues, and overall energy demand.

Though some states, such as Maryland and Missouri, have taken the extreme measure of putting moratoriums on data center development, other states have taken a more measured approach in response to pushback asserted against data center development. For example, the largest electric utility in Ohio proposed charging data centers 85% of transmission upgrade costs to avoid cross-subsidization by other customers.

California enacted the Ratepayer and Technological Innovation Protection Act, which requires the state's Public Utilities Commission to define special electricity rates that prevent cost-shifting while ensuring full cost recovery for grid improvements supporting data centers. Similarly, Oregon has created a separate retail rate class for large data centers to ensure grid upgrade and interconnection costs are allocated to that class while also shifting toward a 10-year minimum commitment model to ensure these costs are recouped.

Ultimately, the combination of changing regulatory and contract frameworks and overarching social pressures creates a challenging environment for the development and financing of data center projects. Increases in up-front costs required to build data centers and interconnect them to the transmission or distribution grid have the potential to strain transaction viability and decrease operating margins.

The high cost of extensive credit support and other performance security requirements also pose significant financial difficulties. Early termination and "make whole" provisions increase commercial uncertainty. Regulatory approvals and cost-recovery frameworks complicate power purchase agreements and interconnection agreements. Collectively, these hurdles threaten coverage ratios and debt capacity.

Efforts to Enhance Project Viability

There are several strategies that, if thoughtfully and cooperatively employed by utilities and data center developers, can help maintain bankability of these large-scale projects:

1. Strategically size projects to meet available incentive thresholds.
2. Embed robust contract protections for cost-sharing and termination. Implement cost-sharing tariffs and pass-through mechanisms to stabilize cost assumptions.
3. Adopt advanced credit structures to mitigate regulatory risk. Use parent guarantees and prepay escrow funds to cover potential termination liabilities.
4. Engage early with regulators to influence policy outcomes. Explore prepayment options for transmission upgrades. Engage with public utility commissions to shape tariff structures and secure favorable treatment. 
5. Stress-test financial models for evolving cost dynamics. Incorporate contingency buffers and stochastic risk analysis for policy-driven cost exposure. 
6. Attract sustainability-focused financing by using renewable energy sources and integrating artificial intelligence to streamline data center operations and enhance energy efficiency.
7. Alleviate community transparency concerns by reporting improvements in environmental impact metrics, ultimately positioning the project for sustainability-linked financing structures such as green bonds, which often require compliance reporting. 
8. Position the data center for future expansion by implementing uncommitted accordion facilities that enable future investment and an increased debt capacity.
9. Collateralize loans for data center development in heavily regulated and restricted areas against data centers within the same investment portfolio that are situated in areas with less regulation and local opposition.

State-level cost allocation shifts and related policies are reshaping the economics of data center development. Through industry collaboration around innovative tariff design, strategic development, proactive regulatory engagement and risk-informed financial modeling, developers can navigate these hurdles and maintain bankability in a rapidly evolving regulatory landscape.

Joshua Belcher and Ram Sunkara are partners and Blaine Remmick and Ryan Kainz are associates with Holland & Knight LLP. They are members of the firm’s Data Center Team and focus on energy-related transactions.