The founding of Sydney marks a pivotal chapter in Australian history, beginning on January 26, 1788, when Captain Arthur Phillip R.N. established the first British penal colony at Sydney Cove. This initiative arose after the American colonies ceased to accept convicts, prompting Britain to seek a new location for its penal system. Beyond addressing the convict issue, advocates for colonization also emphasized the strategic importance of a new base in the Asia-Pacific region, aiming to secure timber and flax essential for the navy.

The First Fleet, consisting of 11 ships commanded by Phillip, arrived at Botany Bay in January 1788. It carried over a thousand settlers, including 736 convicts. Shortly after their arrival, the fleet relocated to Port Jackson, where the settlement was formally established at Sydney Cove. Phillip proclaimed the colony of New South Wales on February 7, 1788, highlighting Sydney Cove's advantages, such as its fresh water supply and secure harbor, which he famously described as "the finest Harbour in the World."

Initially designed as a self-sufficient penal colony reliant on subsistence agriculture, the settlement faced early challenges. Efforts to cultivate crops faltered due to poor soil conditions, leading to several years of hunger and strict rationing. The arrival of the Second Fleet in mid-1790 and the Third Fleet in 1791 alleviated the food crisis. Gradually, former convicts were granted small parcels of land, facilitating agricultural expansion into the more fertile regions around Parramatta, Windsor, and Camden. By 1804, the colony achieved self-sufficiency in food production.

However, the early years were not without tragedy; a smallpox epidemic in April 1789 devastated the Indigenous population, killing about half of the local clans. In November 1790, Bennelong, an Aboriginal man, led a group of survivors into the settlement, establishing a continued presence of Indigenous Australians in the area.

Despite lacking explicit directives for urban planning, Phillip submitted a proposal for Sydney's layout in July 1788, envisioning a central avenue and essential public buildings. However, his plan was soon abandoned in favor of unplanned development, which became a hallmark of Sydney's growth. Following Phillip's departure in December 1792, military officers began acquiring land and engaging in trade, with former convicts opening small businesses. Tensions between commerce and regulation escalated under Governor William Bligh (1806–1808), ultimately resulting in the Rum Rebellion of 1808, where Bligh was ousted by the New South Wales Corps.

Governor Lachlan Macquarie (1810–1821) played a crucial role in Sydney's development, instituting a bank, a currency, and a hospital, as well as overseeing the construction of key infrastructure, including roads and public buildings. Significant projects, such as Parramatta Road—linking Sydney and Parramatta—were completed during his tenure, paving the way for expansive agricultural activities.

After Macquarie's departure, policies shifted towards encouraging the emigration of free British settlers, resulting in a notable increase in population. From just 900 free settlers between 1826 and 1830, numbers surged to 29,000 by 1836-1840, many choosing to settle in Sydney. By the 1840s, Sydney had developed a socioeconomic divide, with poorer residents residing west of the Tank Stream in areas like The Rocks, while wealthier citizens inhabited the eastern parts of the city.

With the demographic shift towards free settlers, free-born residents, and former convicts, calls for responsible governance and an end to transportation grew louder. This culminated in the cessation of transportation to New South Wales in 1840, marking a significant turning point in Sydney's journey from a penal settlement to an emerging urban center.