Water, in minute quantities, is harmful in power equipment because it is attracted to the places of greatest electrical stress and this is where it is the most dangerous. Water accelerates the deterioration of both the insulating oil and the paper insulation, liberating more water in the process (heat catalysed).

This is a never ending circle and once the paper insulation has been degraded (loss of methanical strength), it can never (unlike the oil) be returned to its original condition.

Origins of water
Water can originate from two sources.

Atmospheric
Via the silica gel breather (dry silica gel is always blue).
Via leaks into the power equipment, for example, bad gasketing, cracked insulation, a loose manhole cover and a ruptured explosion diaphragm etc. (if oil can get out, water can get in).

Internal sources
Paper degradation produces water.
Oil degradation produces water.
Wet insulation contaminates the oil (temperature dependent).

Test method: IEC 814