I vaguely remember playing one of OFFICIAL campaigns from either HoMM 3 or Chronicles about ten years ago. My hero had an ability to turn dragons into azure dragons for a cost. My questions are:
1. Is it really a thing, or am I just hallucinating?
2. If it IS a thing, which campaign/mission is it?

1. To the best of my knowledge this is a Halucination.

The only heroes with creature specialties who get to upgrade units are the ones with "Enchanters" and "Sharpshooters". All other creature special abilities give either flat bonus's (like Mutare) or scaling bonus's with levels (like Ivor).

Perhaps in Clash of Dragons, one of the two Chronicles I haven't played yet?

In Clash of the Dragons Tarnum received Sharpshooter specialisation (can upgrade Archers/Marksmen or Elves/Grand Elves to Sharpshooters)

Correct just like Gelu.