Over recent years executive pay has become an increasingly thorny issue. From the 1980’s onwards a growing body of thinking saw executive pay as being the vital spur to entrepreneurial growth but that levels of pay current at the time were not adequate to this. It was important to increase the level of incentive to senior managers and particularly CEO’s so they were appropriately incentivised.

In parallel with this there was a concern about how such incentives could be structured so as to align the interests of executive agents with those of the principal owners. How to align the owners long term interest in the growth of the company with the short term interests of the managers to inflate profits today.

The way around this principal/agent dilemma was to provide stock options. These were options to buy shares in the company at a point in the future at a discount to the current price. If the Executives increased the value of the company its share price would increase thus increasing the value of their share options when exercised.

The development of this theory is explored in Tom Bergin’s excellent new book Free Lunch Thinking. He charts the rise of the theory to the status of common sense and then explores problems raised by reviews of how executives actually perform when their pay is thus inflated.

His point is that the evidence about executive performance does not seem to confirm that it improves with greater pay. His first point is a generic one about the relationship between corporate performance generally and senior pay. He points out that between 1945 and 1970 corporate earnings in the US grew at the highest rate they have in the country’s history. This was a period when CEO’s were paid “like bureaucrats”, eg. in 1965 CEO’s were paid c20 times what the average worker was. By 2018 this ratio had increased to 278 times average earnings, however corporate earnings had declined.

Another problem was the link between successful management and share price. Theory would have it that the share price is the product of a multiple of the earnings of a company. However, the work of economist Robert Shiller who analysed share prices and earnings over a century discovered that the share price was far more volatile than the earnings multiple model would suggest.

For a number of other reasons Bergin finds the link between pay and performance to be tenuous at best. Generally his point is that the agent/principal problem is not sorted by increased pay channeled through share options because the link between performance and reward is not nearly so clear. If principal owners want their executive agents interests to be aligned with the success of their company ever higher pay levels and share options might not be the best way.

This picture seems to cohere with everyday experience that some people are highly motivated and some are not. The correlation of that to pay is not always obvious and any causal link is even more difficult to confirm both in terms of direction and strength.

A major assumption in this model is that the interest of principals and the companies they own are synonymous. The principal wants their company to be a success. This may have been the case in the 19th Century in private companies where all the shares were owned by an individual or family. But in an era of rapid trading the principal may have a fractionally small period of ownership and very little interest in the future success of the company.

An interesting example of this is provided by Shell’s annual accounts for the year 2019. Shell is a fossil Fuel company. In recent years the need to move away from fossil fuel use has become increasingly apparent and increasingly urgent. Given this you might think the company, with an eye to the future, would be devoting substantial resources to a move away from fossil fuels and towards alternative energy sources.

The accounts reveal however that in the year to 2019 the company invested $962m on Research and Development which might include work on renewable energy, but more than twice that amount, $2,354 billion was spent on Exploration which one might assume relates to the search for fossil fuels as we know where the sun and the wind are.

Despite the fact that it faces what many would see as an existential challenge the company feels it has got too much cash. In 2018 it launched a $25 billion share buyback programme and in the 2019 report its CEO was pleased to announce that $14.75 billion of that programme had been achieved by February 2020.

Given the longevity of Shell, which started out in the 19 century importing antiques and sea shells from the Far East, and its scale, its revenues were just under $345 billon in 2019, there are doubtless many long term investors in the company like pension funds. Will they, however, have the same level of commitment to the future of the company as its founder Marcus Samuel, or will they simply shift their investments elsewhere? And for the more frequent traders will there be any interest at all in the long term future of the business over its short term cash flow and share concentration?

Aligning the interests of the agent with the principal has been a long term concern of companies with professional management. What might have been missed is the problem of aligning the interests of both the principal and the agent with the long term interests of the company.