The transition to water cooling in the 911 was done for noise and emissions purposes primarily. A side benefit for them was the ability to buy off-the-shelf HVAC componentry and not have to engineer a heating system based on exhaust heat exchange.
It's very easy to get equivalent horsepower out of an air-cooled engine than the current water cooled models. There are plenty of air-cooled turbos pushing 600hp, and the Singer Vehicle Design 911 engines are producing 400 hp based on the original air-cooled 911 engine.
I would have thought an air-cooled engine would run hotter, therefore burning more of the "bad" emissions before they even enter the exhaust
One of the initial engine designs for the 911 was a twin-fan engine. Apparently it made such a racket that the porsche engineers nicknamed it 'the threshing machine' and Butzi Porsche canned it on the spot.
But the big difference between a Porsche air-cooling fan and a crank-driven engine fan is that a Porsche fan is overdriven and much larger (diameter and blades) than a typical water cooling fan which is typically under driven and has fewer blades.
Given two engines, both optimally designed to approach those limits, air-cooling is not as practical or as efficient as water-cooling. This means that for a given displacement, you'll hit the boundaries of air-cooling before you will water-cooling. If you want to continue to increase your power for a given displacement, you have to find a way to dissipate the wasted heat energy. That leads you to water-cooling.
It's not that water cooling is that much more efficient, but that it scales more easily. With air-cooling, you have limited space around the cylinders for cooling fins. The head is particularly problematic because of the valve gear. With water-cooling, you can increase the dimensions of the radiator in three dimensions to improve heat dissipation capabilities.
1: http://physics.stackexchange.com/questions/98966/maximum-the...