As demand for data centres increases, Europe faces rapid growth but struggles to meet capacity needs. Investors must navigate regulatory hurdles, rising construction costs, and sustainability challenges to succeed, writes Dominic Rowe, Of Counsel in Herbert Smith Freehills’ TMT and Data Practice.

Around the world, data centre demand is outstripping supply – with some estimates suggesting assets in Europe will need to more than double over the next few years if the hunger for them is to be sated.

Geographically, Europe is lagging behind the US on capacity and the race is on to close the gap, with the continent experiencing double-digit growth rates, all whilst Africa and APAC are also seeing unprecedented levels of demand.

Yet, despite this picture of optimism, the prevailing view remains one where supply will fail to mirror demand.

To invest or not; that is the question?

It may be true that the global surge in demand has attracted investors’ attention. Certainly, with the long-term, inflation-linked cash flows and risk-adjusted yields on offer, most commentators would argue that investors will remain interested.

But things are never that simple and it would be naïve to think that investing in data centres is without its challenges.

To begin with it is becoming increasingly difficult to build new data centres in some jurisdictions. Whether this is for practical reasons, such as the lack of suitable land in densely populated urban areas, or legal and planning factors, such as Singapore’s four-year moratorium on new builds.

Even where permission is granted, the rising costs of construction, data centre equipment, and labour rates, and less predictable development timelines, are making it difficult for developers to commit to deliver projects to fixed timelines and budgets, and are requiring increased flexibility to be built into construction and supply contracts.

With some countries adopting restrictions on adding major new loads to the grid, and some (such as the Netherlands and Ireland) pausing new developments in an effort to reduce the strain on power grids, investors are also questioning when or whether they will see a return on their investment. It’s no surprise, as rapid growth in data centre demand has been matched by a similarly rapid growth in the regulatory regimes. In my view, those classifying the processing and storage of data as being ‘critical infrastructure’ will likely continue as a trend.

Circumventing barriers to success

Most people agree that the key to the development of new data centres is securing land in suitable locations, along with the requisite rights over such land. However, successfully navigating the relevant consenting processes for data centres involves a delicate balancing act of interests in what can be a highly political climate.

Understandably, consenting authorities are increasingly focused on sustainability – so for those looking to create new data centres, it is worth highlighting how any sustainability synergies resulting from a new development could prove significant. Think, for example, about connecting the data centre to local district heating networks to deliver waste heat as a heating source for surrounding communities.

Of course, managing business-critical ESG impacts requires continuous analysis of supply chains to ensure they are compliant and have robust governance processes in place. After all, without these, how can risks be identified to protect capital investment or even raise debt that satisfies relevant environmental policies and investors’ ESG mandates?

To put this into context, significant recent developments relating to misleading conduct in ‘green’ and ‘social’ claims has ensured regulators are increasingly shining a light in this space, meaning that data centre sponsors and investors must become responsive to potential risks from making misleading claims about environmental and sustainability commitments.

Even if initial hurdles are overcome, the fact that data centres are – rightly – considered to be critical data storage and processing assets means they are also attracting enhanced security obligations in some jurisdictions.

Many jurisdictions have also introduced legislation to enable intelligence agencies or other government bodies to intervene, audit, and secure data centres in the interests of national security. This includes powers to enforce ownership or governance requirements, or directing that customers meeting certain criteria are prohibited from using the data centre (effectively precluding operators of data centres from providing services to certain sectors).

Making data the centre of success

Despite the plethora of barriers, my view is that anyone claiming the barriers are too tall is failing to analyse what the data is trying to tell them. 

For one thing, success can be dependent on the ownership structure. Rather than ‘going it alone’, joint ventures, with equity interests determined by the value of the operator’s contributions in the form of data centre assets and offtake agreements, can help mitigate risk. Part of this should also include a governance regime that requires consent to be obtained with respect to various matters, corresponding to ownership interest. In the context of data centre joint ventures, a matter which is particularly important is material amendment or termination of any customer contract.

Investors, particularly those investing from close-ended funds, will also need to ensure there are appropriate avenues to achieve liquidity. Typically, after a lock-up period, a minimum percentage of shareholders are entitled to initiate an IPO, recapitalisation, or combination of the group with another business. In other words, exit strategies outlined at the beginning could be your key to success.

Ultimately, as technology advances our collective desire for – and creation of – data is only going to grow. It means that if the thirst for data centres is going to be quenched, those at the helm of the data centre (r)evolution will have to pay close attention to the rapidly changing legal, regulatory and financial demands being placed upon them. In other words, they need to understand and analyse the data at the centre of what promises to be an exciting opportunity.