The UK’s new Government has put forward plans to privatise parts of Royal Mail, and has suggested that there will be opportunities for employee ownership. This could be a sensible move to help make any privatisation a success – but only if it is done right.

Almost all large organisations are faced with an issue known as principal-agent risk. This is the risk that when the owner of an organisation – the principal – appoint someone to act on their behalf – the agent, then the agent will actually put his or her interest above those of the principal. This is not to say that all director and managers are duplicitous and corrupt, but people will naturally have a tendency to look after their own interests first.

The key to avoiding this behaviour is to align the interests of the principal and the agent somehow. In the context of a firm, where shareholders appoint directors to manage the firm on their behalf, one solution is to encourage directors to own shares in the firm. This means that if the firm performs well, the directors gain a direct financial benefit, encouraging them to manage the firm to the best of their ability.

In the context of Royal Mail, the principal – in this case the Government – will be also be interested in efficiency and, as a result, profit. This means that, on the face of it, turning employees into shareholders is a good idea. However, if the shares can simply be sold at any time, then all that has happened is that employees have been given a sweetener to encourage them to accept privatisation without being given any long-term incentive to do their best for Royal Mail.

One alternative is to give employees notional shares in proportion to their service with Royal Mail, and with more notional shares being earned over time. These shares would have the same price as any “real” shares being bought and sold on the stock exchange. They would also pay real dividends to their holders, but could not be bought and sold. They could, however, be converted to additional pension at retirement, or converted to units in a notional personal pension on leaving Royal Mail before retirement. This would reward Royal Mail employees, maintain the appropriate incentives, and hopefully encourage long service. It would also motivate the long stayers – who would also, hopefully, be the most respected employees – to encourage their colleagues to work hard.

The system is, of course, imperfect. First, there is the free rider issue. In an organisation the size of Royal Mail, the impact of any one individual is likely to be trivial – why work hard when the impact on the final pay packet is so small? This issue could be dealt with by notionally dividing Royal Mail into a large number of smaller firms, thus increasing the impact of each individual’s actions.

However, the bigger issue is that this financial approach ignores the quality of service. There are a number of ways that service quality could be built into this model, but the most consistent with the approach described above would be to introduce an element of competition. The risk that profits could be hit by falling volumes of business would hopefully mean that a high standard of service would be something that workers would strive for if its impact on pay packets could be seen.