Legal Considerations for Data Center Development and Operation Project (2) – The Nature of Customer Contracts, Permits and Licenses, and Power Procurement –

The Legal Nature of Contracts with Customers

In order to discuss the regulations applicable to the data center business, it is necessary to first describe the legal nature of the contracts that data center operators and customers enter into regarding the data center business.

In hyper-scale data centers, it is typical for a data center operator to grant customers the right to use space within the data center, as well as to provide power, air conditioning, and various ancillary services. The legal nature of the contracts between data center operators and customers concerning these matters can vary. If the emphasis is on the granting of the right to use space within the building, the contract could be considered a property lease agreement. On the other hand, if the focus is on the provision of services, it may be considered a service contract (i.e., a service provision agreement). In practice, there are often cases where the contract does not clearly specify that it is either primarily space-related or service-based, or where other forms of agreements are adopted in which the nature of the agreement is similarly difficult to classify.

In Japan, however, it is important to note that if a contract is classified as a building lease agreement, the mandatory provisions of the Act on Land and Building Leases (the “ALBL”) will apply thereto※4. Specifically, this entails that, unless it is a fixed-term building lease agreement (ALBL, Article 38), the landlord’s ability to refuse a lease renewal requires justifiable grounds (ALBL, Article 28), thus limiting the landlord’s ability to terminate the contract. Additionally, the tenant would have the right to request a rent reduction (ALBL, Article 32).

In this regard, even if a part of a building is divided by barriers or other means and has a structure and scale that allows for exclusive control, it is considered a “building” under the ALBL※5. However, there are also cases where the ALBL has been found not to apply to portions of a building※6. For data centers, applicability will likely be determined based on facts such as the scope of the area used by the customer, its independence, the possibility and method of modification, the method and manner of external access, and whether the data center operator can enter the relevant portion of the building.

It should be noted that even if the contract between the data center operator and the customer is named a service contract, colocation contract, license agreement, etc., or stipulates that no leasehold right arises or that the ALBL does not apply, this will not necessarily prevent the application of the ALBL, and the decision as to whether the ALBL applies will be based on the actual circumstances of the use of the property※7.

Furthermore, especially when adopting GK-TK structures or TMK structures, in addition to the regulations applicable to each entity (typically, the prohibition on engaging in other businesses for TMKs), it is necessary to consider the various regulations applicable to the services provided to customers, as will be explained in the following section 3. In light of these considerations, it may become necessary to carefully consider the structure, parties, and content of contracts with customers with respect to which entity should provide which services to the customers※8.

Main Regulations Applicable to the Data Center Business

Various regulations may apply to the data center business, and the following provides an overview of major regulations related to the provision of services to customers that often become points of discussion in the development and operation of data centers※9.

1. Telecommunications Business Act

The use of telecommunications equipment to mediate the communications of end-users, or otherwise making telecommunications equipment available for end-user communication is categorized as telecommunications services (Telecommunications Business Act, Article 2, Item 3). In order to operate a telecommunications business, i.e., a business providing telecommunications services※10, as a general rule it is necessary to either register (Telecommunications Business Act, Article 9) or submit a notification (Telecommunications Business Act, Article 16), and attention must be paid to regulations under the Telecommunications Business Act.

Where real estate companies and similar entities develop buildings equipped with power supply facilities and earthquake resistance facilities and lease them as server installation locations to telecommunications business operators, this is deemed not to fall under telecommunications services because it merely involves leasing space as real estate business. However, if the service provider itself procures telecommunications lines and provides them to service users, it is considered a resale of telecommunications services and requires registration or notification as a telecommunications business※11.

In many cases, notification alone, without registration, is sufficient for data centers. However, in practice, it is often necessary to consult with the competent communications bureau and to present them with a network configuration diagram.

Regarding special purpose companies (hereinafter TMKs or SPCs), it is considered difficult for them to be the entities responsible for registration or notification due to the prohibition on TMKs engaging in other businesses. Therefore, in a TMK structure, it is necessary to consider leasing the data center to a data center operator or having another SPC as a master lessee, and having this data center operator or SPC perform the registration or notification.

2. Construction Business Act

In data centers, even after the initial construction work is completed and operations have commenced, it is often necessary to carry out additional work, such as electrical work in response to customer requests or customer replacements. The business of contracting the completion of such work falls under the legal definition of construction business (Construction Business Act, Article 2, Paragraph 2). With the exception of minor work, where the contract amount for a single project does not exceed 5 million yen, any such post-completion work requires a construction business license (Construction Business Act, Article 3; Enforcement Order of the Construction Business Act, Article 1-2, Paragraph 1)※12.

In this regard, if the data center operator directly contracts with a licensed contractor for construction work with respect to assets that belong to the data center operator, or if the customer does so directly for assets that belong to the customer, no unique issue presents itself. Depending on the structure, however, multiple parties such as the customer, the data center operator, and the SPC owning the building may be involved in contracting for construction work, and it could become an issue whether the data center operator or the SPC is engaging in actions that qualify as construction business as the prime contractor※13.

3. Security Business

In data centers, it is necessary to ensure physical security at all times. Regarding on-site security at data centers, if this is conducted “in response to the needs of others” (i.e., if security is provided for any parties other than the data center operator itself) as part of so-called facility security services※14, it falls under the legal definition of security services (Security Services Act, Article 2, Paragraph 1), and it is necessary to obtain relevant certification under the Security Services Act with respect to the provision of such services (Security Services Act, Article 4).

For data center operators who own or lease entire buildings and conduct security operations within their own operated data centers, the security services can be organized as an activity carried out as their own business rather than “in response to the needs of others.” Similarly, it is considered acceptable for such data center operators to contract security services to a security company. However, similar to the case of construction businesses, when multiple parties are involved, it may become an issue whether the data center operator or SPC is engaging in security services (including cases where services are subcontracted from a security company).

4. Waste Management and Public Cleansing Act

Regarding waste generated at data centers, it must be disposed of in accordance with the regulations of the Waste Management and Public Cleansing Act (the “Waste Management Act”). Business operators are responsible for the proper disposal of waste generated from their business activities (Waste Management Act, Article 3, Paragraph 1). Industrial waste (Waste Management Act, Article 2, Paragraph 4) must also be disposed of by the business operator itself (Waste Management Act, Article 11, Paragraph 1). If the transportation or disposal of industrial waste is entrusted to another party, this must be an industrial waste collection and transportation operator, an industrial waste disposal operator, or another person specified by the Ministry of the Environment as stipulated in the Waste Management Act, Article 14, Paragraph 12. A management manifest must also be issued at the time of transfer of the industrial waste (Waste Management Act, Article 12-3).

As mentioned above, ownership of various assets in data centers can be a complex determination varying on a case-by-case basis, and it is often difficult to determine which entity is the waste generator in the data center for waste management purposes. It is also important to note that, under the Waste Management Act, as a general rule it is prohibited to re-entrust the collection, transportation, or disposal of industrial waste to a third party, except when strict criteria are met (Waste Management Act, Article 14, Paragraph 16).

If the customer is the waste generator for industrial waste, the customer may need to arrange for collection and transportation or disposal with industrial waste collection and transportation operators or industrial waste disposal operators. Moreover, attention should be paid to whether the data center operator is considered to be entrusted with the disposal of industrial waste generated by the customer’s operations, as this may require a permit under the Waste Management Act (Waste Management Act, Article 14, Paragraphs 1 and 6).

Procurement of Electricity

In operating a data center, a vast amount of electricity is consumed. It is estimated that electricity costs account for up to 25% of the operating costs, including equipment, buildings, and personnel expenses※15. Furthermore, to attract hyperscalers that demand carbon-free energy sources, data centers face increasing pressure to not only improve energy efficiency but also to procure large and stable amounts of renewable energy-derived electricity from external sources.

There are several methods to procure electricity derived from renewable energy, but recently the direct procurement of renewable electricity from specific renewable energy power producers (a power purchase agreement or PPA) has been a commonly used method (including by data center operators). For data centers specifically, an offsite PPA is the most likely method of procurement, pursuant to which renewable energy produced by power generation facilities operated by distantly-located third-party power producers (e.g., wind farms in rural areas) is supplied to data centers near metropolitan areas.

Corporate PPAs come in two forms: (1) physical PPAs, by which electricity is supplied to consumers via the power grid, transferring both electricity and environmental attributes from the power producer to the consumer; and (2) virtual PPAs, by which the power producer sells electricity on the market or to other businesses, while the consumer also physically draws electricity from a retail electricity provider other than the power producer, separating and transferring only the environmental attributes※16 to the consumer.

In the case of a physical PPA, the transfer of electricity (accompanied by environmental attributes) from the power producer (owner of the renewable energy generation facility) to the consumer (such as the data center operator) requires registration as a retail electricity provider under the Electricity Business Act, because it constitutes retail supply (providing electricity in response to general needs). Consequently, a retail electricity provider must mediate between the power producer and the consumer, with the power producer supplying renewable electricity to the retail electricity provider, and the consumer directly purchasing renewable electricity from the retail electricity provider.

On the other hand, a virtual PPA involves the power producer separating the environmental attributes from the electricity and providing only the environmental attributes to a specific consumer, while setting a fixed price known as a strike price with the consumer and reconciling the difference between the market price of electricity and the strike price.

There are many points to consider when introducing any form of corporate PPA. For instance, in a physical PPA, consumers like data center operators must assume the credit risk of the retail electricity provider to some extent. In a virtual PPA, consumers take on the risk of price fluctuations in the electricity market, so they must consider risk mitigation measures with respect to same. Furthermore, negotiating a corporate PPA contract, whether for a physical or a virtual PPA, typically involves significant effort. For power producers, the offtake agreement is key to both recovering the development costs of renewable energy generation facilities developed with substantial investment, as well as to ensuring returns. If the power producer has obtained financing through project finance, the preferences of the lenders also must be taken into consideration. The consumer must ensure that negotiations with the power producer take into consideration key commercial terms, such as contract duration, terms of supply for electricity and environmental attributes, payment conditions, and the allocation of risks related to regulatory changes and force majeure.

Moreover, in the development and operation of a data center, other electricity-related issues must be considered based on the specifics of the project. These include determining who should own the power reception equipment (the SPC or another party), which entity should be the consumer entering into the retail supply contract with the retail electricity provider, and whether it is possible to supply electricity received through a single power reception facility (bulk power reception) to customers located in multiple buildings. These decisions should take into consideration not only the Electricity Business Act but also regulations under the Act on Securitization of Assets and other relevant laws, so careful attention is required.