Should be fine. Let's not forget, the game will compensate for that permanent state.
... Alternatively, how about tweaking how fast the game adapts to it? Do we know? Is it instant the moment you go to a new floor and it generates monsters, or does it happen over time? The original comment implies it's not instant. Might be interesting if acquiring a permanent state makes the game force the player into a play-style based around said state.
While true, it seems unnecessary to put in an entire mechanic that only gets used in one or two circumstances. Personally, I think we should simply deal 1HP head damage accompanied by a message saying you're running out of air or something. That can be a quick fix until we work out whether or not this "breathing" mechanic is something we want, along with where and how it's going to be used.
So long as you hold the Skull of Xinroch, dark knights and evil spellcasters will obey you without question. This gives you easy passage back, or the option to head that army and return to Attnam and rescue the imprisoned necromancer. Victory can be declared upon entering the catacombs, or if that's too easy, upon freeing the necromancer then exiting Attnam.
Also, I don't see how Shadow Veil will be too OP. Even if you're hiding in the walls, you're still subject to spells, and it won't protect you from being attacked if you're next to an enemy. Seems to me that 0 AV will balance out the ethereal nicely.
Normally Xinroch uses a sword and shield; red_kangaroo suggested having him dual wield as in the story. Except since the story is based on the game I had one of them become lost.
I also made a suggestion that for additional length we could have another dungeon.
Well, what if the additional dungeon was in pursuit of Xinroch's final form, and the final form has the other flaming sword? We can make it an artifact to reward players for beating Xinroch once and for all.
As stated above, the player learning to swim is redundant right now. That said, I can see some potential in letting the player swim if we make underwater levels possible, with diving/surfacing acting as descend/ascend stairs.