Following years of debate over where Sydney might build its third cruise ship terminal, the NSW Government has announced it wants to work with industry on a potential site in Port Botany.

The State Government has launched the first phase of the "detailed business case" to look into the option for an additional cruise terminal at Yarra Bay or Molineux Point.

This follows the Federal Government's 2018 decision to reject plans for cruise ships to dock alongside naval vessels at Garden Island in Sydney Harbour.

A third terminal is hoped to increase the capacity for cruise ships in the harbour city, with the Overseas Passenger Terminal in Circular Quay and White Bay struggling to meet demand in peak season.

"The cruise industry creates $2.75 billion for the state's economy each year," Minister for Transport Andrew Constance said in a statement.

"We're expecting almost 1.6 million passengers this cruise season alone."

"This potential terminal at Port Botany would address the capacity constraints we're seeing at the Overseas Passenger Terminal."

Yarra Bay and Molineux Point are the two sites flagged as the potential location for Sydney's third cruise ship terminal. ( Supplied: NSW Government )

While the White Bay Cruise Terminal alleviates some pressure from the Circular Quay terminal, it can only take those vessels which fit under the Sydney Harbour Bridge.

And without a third cruise terminal, Sydney Harbour master Philip Holliday said, tourism would suffer.

"If you're a cruise company trying to get your ship into Circular Quay — especially during the peak months of January, February, March — most people will know that just by looking at it, there's a ship there every day," Mr Holliday told ABC Radio Sydney's Breakfast program.

"If you're a new player or you want to grow your business, we just don't have the capacity."

According to the State Government, the newly announced business case project will assess the social and economic benefits, costs, and impact on traffic, transport, heritage and environment — including recreational fishing — at both potential sites.

Mr Holliday said it was hoped a third terminal would increase Sydney's capacity to host cruise ships.

"In the first instance we'd be talking about 40 ships a year, and we'd start to grow from there," he said.

"Each ship typically comes around at around 6:30 in the morning and sails around 4:30 in the afternoon."

"There would be a bit of a peak in the morning and a bit of a peak in the afternoon, but all of the plans that are being developed take that into account."

Council to fight proposal

Yarra Bay has been earmarked as one of the potential sites for Sydney's third cruise ship terminal. ( Instagram: @darkrozez )

Randwick Council Deputy Mayor and Save The Bay coalition member councillor Danny Said believes the language being used by the Government is misleading.

"By calling it Port Botany … [when] it's actually going to be built in Yarra Bay, which is a swimming beach, it gives it a better glow," Cr Said said.

"It's not part of the port, it's actually Yarra Bay which will be destroyed."

"Surely people want to go to the harbour," he added.

Despite the latest State Government update acknowledging the market engagement process would include consultation with the community, the councillor said it was too little too late.

"We've never been consulted, the community has never been consulted," he said.

"And that's why council took a resolution that we would put $50,000 on research as to why it should not be there."