Protected areas (PA) provide conservation benefits and ecosystem services that spill over the boundaries of jurisdictions to other regions. In this paper we analyse the foundations of and design options for ecological fiscal transfers (EFT) that may internalize such positive external effects. We propose a model for integrating ecological indicators into the intergovernmental fiscal transfer system between federal and state‐level governments in Germany. Our approach is performance oriented and would thus compensate those states that designate an above‐average share of their area for nature conservation purposes. The suggested EFT design builds upon the existing fiscal equalization system and complies with the legal requirements for indicators determining fiscal needs. We employ an econometric analysis to demonstrate that, on average, sparsely populated states in Germany provide more PA per capita and would thus be eligible for increased fiscal transfers. A quantitative model of the fiscal transfer scheme is then used to estimate the marginal financial effects of integrating ecological indicators into federal–state fiscal relations in Germany. Moving beyond the specific case presented, we discuss the implications in terms of the specific role of EFT as a policy instrument within the broader conservation policy mix. Copyright © 2017 John Wiley & Sons, Ltd and ERP Environment