Ah, so Escape is a built-in VBScript function that escapes a string into valid URL format. I thought it was a function you wrote to convert newlines to something else. To do just that instead, something like this would work (and you don't actually need to use vbld_EscapeString on FAILSTEP_OUTPUT, since special characters will already be escaped -- the Escape method is what was adding non-VBP-escaped chars):
SELECT build_seterrortext('%BUILD_KEY%', %CURRENT_STEP%, '[Replace(vbld_AllMacros().Item("FAILSTEP_OUTPUT").V alue, vbCrLf, "")]');
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