For an individual irrigator water use efficiency increases in response to investments in on-farm capital. Sustainable river systems require sufficient flows to maintain the value and function of natural capital assets. In constrained water resource settings, federal basin managers may view on-farm capital investments as a policy objective to rebalance water shares between all users to offset negative externalities from over allocation. This paper uses a state contingent modelling approach to review an extended farm capital investment policy in Australia’s Murray-Darling Basin. We examine technical efficiency gain implications for irrigation and environmental water managers under alternative states of inflow variability and the role increasing climatic uncertainty has on policy objectives. Results suggest that the incentives provided to recover environment water via on-farm capital investments could have two principal negative feedbacks given future uncertainties. First, farm capital investments may encourage inflexible production systems that fail to respond to future water scarcity, exposing that investment to increased risk. Second, technical efficiency gains may reduce return flows leading to perverse policy outcomes to achieve environmental objectives. By highlighting these ulterior policy outcomes it provides both irrigators and policy makers the capacity to adapt and increase their flexibility to develop robust policy and management solutions to help negate future uncertainty.