Understanding the connotation and principles of ecological compensation in water source reserve areas is the basis and guarantee for establishing and improving the ecological compensation mechanism of water source reserve areas.First,this paper reviews the three stages of ecological compensation research progress.Based on the review,using the theory of externality,the ecological environment system of water source reserve areas is then analyzed.This paper argues that the connotation of ecological compensation in water source reserve areas is a kind of institutional arrangement,which is designed to internalize externalities.Finally,based on the understanding of the connotation of ecological compensation in water source reserve areas,five principles for establishing and improving the ecological compensation mechanism are proposed,including the principle of fairness and justice,the principle of equivalence of equality and responsibility,the principle of flexibility and effectiveness,the principle of “earmark funds,and implementation by law,” and the principle of government compensation supplemented with market compensation. Understanding the connotation and principles of ecological compensation in water source reserve areas is the basis and the guarantee for establishing and improving the ecological compensation mechanism of water source reserve areas. First, this paper reviews the three stages of ecological compensation research progress. Based on the review , using the theory of externality, the ecological environment system of water source reserve areas is then calculated.This paper argues that the connotation of ecological compensation in water source reserve areas is a kind of institutional arrangement, which is designed to internalize externalities. Finally, based on the understanding of the connotation of ecological compensation in water source reserve areas, five principles for establishing and improving the ecological compensation mechanism are proposed, including the principle of fairness and justice, the principle of equivalence of equality and responsibility, the principle of flexibility and effectiveness, the pr inciple of “earmark funds, and implementation by law, ” and the principle of government compensation supplemented with market compensation.