My thinking is that The Water Babies story is kind of complex for the picture book age range. Also, there are a few too many kiddy deaths for my liking (plus a drowned dog.. mustn't forget the dog). However, the imagery the book conjures up is just asking to be picturebookified.
So, I've tried to simplify things right down. I've retold just the beginning section of the story, which (fingers crossed) seems to work as a short story in its own right.