Download and read the water heater manual's instructions on venting and how close it can be to other things. Also check your local building safety codes.

ANSWER: REPLACE

https://www.air-conditioning-heating.org/

Thank you Marc. Is this something I can do myself with gloves and mask? I heard that it is dangerous to touch or breath in. What is your reason for replacing? Suspect mold spores?

Don't replace it (fiberglass doesn't go bad with age, unless it gets moldy). Cover it up with drywall but DON'T wall in the water heater - it's a regular water heater that uses indoor combustion air. You can't wall them off, its not safe.

It looks like from the picture the fiberglass has black soot on it. That usually means there is air infiltration from the outside. For that reason I suggest you remove the insulation and seal any air leaks. You can do this yourself with caulking. You would then buy new insulation with a paper face backing. The paper side will face the laundry room. The insulation needs to be covered with dry wall. This is something you can also do yourself.

You could build a closet around the hot water heater but the door needs to have louvers in order for air to enter for combustion. You would have to move the washing machine over to the right in order to make the closet large enough so you can get to the hot water heater if it needs to be replaced.

Click on the pix, folks. You will see that the water heater venting makes closeting the water heater impossible. Beside the fact that there isn't enough room between the laundry machine & the water heater to build a closet wall and maintain safe clearance. Gas water heater.

What's that tall rectangle thing to the left of the hot water heater? Looks like it has legs.