Regions often consist of both urban, densely populated areas and rural, more remote areas. In contrast to the acknowledged socio-economic functions of urban agglomerations, rural and remote areas usually provide ecological services for society as a whole. A number of these ecological services cause costs within the jurisdiction concerned but externally benefit others. Therefore, the aim of this paper is to analyse the role fiscal federalism and fiscal instruments can play in addressing the imbalance of socio-economic and ecological public functions assigned to urban and rural areas in regional development. For this purpose, an investigation of the different role of socio-economic and ecological functions in intergovernmental fiscal relations is carried out by way of example for the Federal Republic of Germany. Due to the significance of ecological functions for regional sustainable development, intergovernmental fiscal relations between the state and the local level of government should take into consideration appropriate ecological indicators. Based on a status quo analysis of the German state fiscal equalisation laws, the paper presents options for systematically integrating ecological functions and indicators into the existing legal framework. Environmental federalism would then be realised regarding both the ecological functions and the financial resources to secure the provision of ecological services. This would fulfil a basic prerequisite of sustainable development taking into account ecological, economic and social aspects for fiscal instruments of prime importance to the local and regional level of government, thereby helping to make regional sustainability a reality.