Powering Progress Episode 11 – The Incentive Challenge: Navigating the New Tax Landscape for Data Centers

Aubrey Bishai [00:00:09]

Welcome back to Powering Progress, a podcast series exploring the infrastructure, energy, and market dynamics shaping the next generation of data centers and AI development.

I’m your host, Aubrey Bishai, Chief Innovation Officer at Vinson & Elkins.

As AI infrastructure investment accelerates, developers, investors, and operators are making long-term decisions based on assumptions about power, financing, and regulation and taxes.

But one of those assumptions is changing.

For years, states competed aggressively to attract data center investment through generous tax incentives.

Today, however, several states are reevaluating those programs, introducing new taxes, pausing incentive offerings, or reconsidering policies that many investors once viewed as stable.

In this episode, I’m joined by Kathy Pakenham, Co-Head of Vinson & Elkins’ Tax Controversy Practice, to discuss the rapidly evolving tax incentive landscape for data centers.

We’ll explore why tax certainty has become a strategic issue, how recent developments are affecting project economics, and what owners, developers, and investors should be thinking about as they evaluate opportunities across different jurisdictions.

Kathy, thank you so much for joining us on Powering Progress.

Kathy Pakenham [00:01:53]

Thanks, Aubrey. Great to be here. I look forward to talking to you about taxes today.

Aubrey Bishai [00:01:57]

So for years, states competed aggressively to attract data centers through tax incentives. What’s changing today, and why are we seeing states rethink those policies?

Kathy Pakenham [00:02:11]

It’s such a great question, Aubrey, and you’re absolutely right. For years and years, we’ve seen a ton of competition between states in order to attract data centers, but there’s been a real shift recently. And I think that’s primarily because of two things.

One, the fiscal costs to taxpayers of incentives greatly exceeded the amounts that states estimated them to be. And second, voters are starting to connect data centers to their electric bills.

And those two things are coming together at the same time, bringing a lot of political pressure into states to rethink their policies around exemptions for taxes related to data centers.

Aubrey Bishai [00:02:54]

Virginia’s recent electricity consumption tax received a lot of attention. Is that an isolated development, or does it signal a broader shift in how states may approach data center taxation?

Kathy Pakenham [00:03:10]

I think the Virginia example is a really good one to start the conversation with, because I think what it will turn out to be is not a one-off Virginia-centric proposal, but really more of a broader signal. I think this is the kind of template that states will be looking at more broadly as they’re thinking about how are they going to regulate and tax data centers more broadly.

So just for those who aren’t familiar with the way that the Virginia electricity consumption tax will work is that it is focused on a per-kilowatt-hour fee on electricity consumed at each data center. And it is that kind of template that I think states are going to be watching very, very closely.

Now, the story isn’t finished in Virginia yet. There is a joint legislative work group that is underway. So I think we’ll be seeing more coming out of Virginia and some more detail. But this is exactly the kind of structure or template that other states will really start to investigate and think about bringing forward in their own jurisdictions.

Aubrey Bishai [00:04:14]

Kathy, one of the themes in your recent article is that developers can no longer assume incentives will remain in place for the life of a project. How does that change the way companies evaluate investments?

Kathy Pakenham [00:04:30]

Well, the incentive risk really has moved out of the footnotes into an underwriting variable for data center development. The real question now is how do you underwrite the asset without the incentive and treat the benefit potentially as an upside, depending on what the probability is that the incentive will last the life of the project.

In other words, I think that projects are going to need to be priced with the assumption that exemptions or other incentives will not be available, to be gravy. We do see grandfathering, generally speaking, in all of these new provisions that are coming out. But even since I published that article that you referenced, three or four more states have also come forward with changes to their incentive programs.

I will say that there is one interesting footnote, which is that Kentucky, in fact, came out with a proposal that would expand the incentives that are available. So we at least see one state stepping in to become more competitive with other states in order to attract more data center development.

So I think that incentives rarely decide whether a project gets built. I think the real issues there are power and land, but they do influence where. And so increasingly there’s a downside to manage rather than an upside to chase.

Aubrey Bishai [00:05:58]

You’ve also written about securing vested rights and revisiting contractual risk allocation. What practical steps should developers and investors be taking today to better protect themselves?

Kathy Pakenham [00:06:14]

I think there’s probably three buckets I would put that into. The first one is lock in what you have. The second is allocate what might be coming. And the third is paper your reliance on incentives. These are all described in a little bit more detail on some of the things that we’ve published.

But I would say, with respect to the first one, if there are vested rights, secure them early, document them carefully. The pauses that have been enacted this year generally maintain existing agreements. But each of the states really is drawing the line between a protected agreement and an unprotected application differently. And administrative pauses take effect with little warning.

For example, New Jersey’s EDA paused with no legislative action at all. And I think, for example, the recent pause in New York also came as a surprise to a lot of people. So I would say accelerate execution of definitive incentive agreements, scrutinize the effective dates, and preserve contemporaneous evidence of reliance in order to secure those rights.

With respect to revisiting contractual risk allocation, leases, co-location agreements, PPAs that were negotiated when incentives were stable may not actually contemplate a consumption-based tax like Virginia’s. And there’s a real open question as to who bears a new kilowatt-per-hour tax like the one in Virginia. So in pending deals, I would make sure that you’re really carefully negotiating that allocation, or contemplating allocations in the event that there are new taxes coming into effect like the one in Virginia.

And then I would say engage with regulators, in particular in those states where there are studies pending. So for example, Virginia has a working group, New Jersey has a development authority — both of those groups are going to shape the next round of legislation. So I would try to engage with those regulators as soon as you know that there is some process underway, to try to craft what might be coming out of those working groups.

Aubrey Bishai [00:08:26]

We’re seeing more states balance economic development with concerns about energy consumption, infrastructure costs, and taxpayer impact. So how do you expect that policy debate to evolve over the next several years?

Kathy Pakenham [00:08:46]

I think you’ve put your finger on it. I think the question is shifting from whether or not to subsidize, to a more nuanced consideration of how to price or to condition those subsidies.

Most states aren’t trying to necessarily entirely stop data centers, but they’re trying to renegotiate the terms under which data centers can be built in their states and how they’re going to be underwritten.

So I would say, for example, New York is on the leading edge here. On July 14th, Governor Hochul issued an executive order that has the first moratorium on new data centers of 50 megawatts or more. At the same time, she announced plans to pursue the repeal of sales tax exemptions. So that’s two things at the same time — one, a pause on the exemption, but also a change in what the state will permit to be built.

I think you’re going to see more conditions-based incentive packages, so things that will require things like ratepayer protection, self-supply and power, water and energy efficiency, transparency and reporting. I think that’s the trend that we’re starting to see — that where the states are going to keep their incentives, they’re going to be conditioned on meeting certain kinds of requirements.

But again, I guess I’ll just add to that — I think there’s a lot of uncertainty here as well. So for example, if AI demand projections soften, or if states take a lot of political heat for losing more key projects, some of this pullback could reverse itself. So states watch each other in both directions. I think the Kentucky example that I cited earlier is a good example of that.

Aubrey Bishai [00:10:38]

Do you think we’ll continue to see states competing primarily on tax incentives? Or do you think other factors such as power availability, permitting speed, and grid reliability will become even more important differentiators?

Kathy Pakenham [00:10:56]

I think power is already the primary currency and taxes may be more of a tiebreaker. I think they’re increasingly going to be viewed as a downside risk to manage rather than an upside.

So what I mean by that is states were competing by offering tax incentives. But now I think it is going to be the question of whether states are imposing additional taxes that actually become a downside to manage, as opposed to an incentive that might be drawing taxpayers — or, excuse me, developers — into a particular state.

So to summarize, I would say, development goes where there’s power and speed to power. I don’t think anybody is building a campus because of a particular sales tax exemption, but nobody wants to be the anchor tenant when an exemption disappears mid-lease either.

Aubrey Bishai [00:11:52]

Kathy, this was incredibly insightful. Thank you so much for joining us.

Kathy Pakenham [00:11:57]

Thanks for having me, Aubrey.

Aubrey Bishai [00:11:59]

Thank you, everyone, for listening to Powering Progress from Vinson & Elkins. For more insights on AI infrastructure and the forces shaping the data center economy, visit velaw.com.