I think they probably started out wanting to do a genuine open world comparable in scope to Skyrim, but they got a ways into the project, realized they were over their heads, and that they also didn't want to start over on their quest/LOD/optimization/level/lighting/AI etc...tech they built out for the semi-open hub world of separate levels in TOW, and just decided instead to make a medieval mod of TOW. Maybe after a reboot they decided that anyway.
It's a shame, but from a tech perspective it's understandable. There is a significant gulf between even quite large levels connected with loading screens, and a genuine open world that cleverly hides all the loading in and out in a seamless and performant way.
There are a few AA-AAA quality, Unreal engine, open world (and sometimes content-dense) Unreal Engine games that have released and done well:
Ark
Hogwarts Legacy
PUBG
Sea of Thieves
Days Gone
Conan Exiles
Fortnite
And more in development, so Unreal is not the limitation. I suspect those studios just had/have more experience with AAA, 3D, open world dev. Obsidian's claim to fame is mostly using either the Creation Engine to make what amounts to a mod of an existing game (ie FNV) where they could just focus on the writing + making a few new assets, or in using Unity for 2D/Isometric games (POE/Tyranny/Pentiment) where, again, the writing is front, and center and all the minutiae of 3D animations and graphics, and gameplay in first person up close, were not relevant. They did of course also make Grounded, but it seems like that game has a cartoony art style, restricted vistas, not that large or open of a world, is not an RPG, does not have complex combat, is AA at most in its production values (14 person team?), and was also not made by the same TOW/Avowed team anyway.
Honestly, it's a bit strange that this studio tried to make TOW, and that they are now trying to make a game like Avowed. It would have made more sense for Microsoft to have founded or purchased an existing studio with experience in AAA, 3D, First Person, Unreal, Open World Games, and just sent them a few of Obsidian's writers (they could have even still called it an Obsidian game for marketing purposes if they wanted to I guess?). There's not really that much overlap in skillset between Unity/C#/2D/writing/narrative focused games and Unreal/C++/3D action/combat focused games.
That is to say, TOW wasn't, and Avowed won't be, a genuine open world game, because Obsidian couldn't figure it out. They just aren't capable of making Skyrim.
Oh well, I guess the gap in the market for a non-TES Skyrim-like game remains empty.