I definitely agree the difficulty system has always been overtly simplistic. And no pun intended here's a simplified version of how I'd do difficulty.
Story Mode: Easier than vanilla Skyrim on moderate difficulty. There is no durability system, magicka comes back quickly like in Skyrim, diseases aren't that big of a deal, and enemies are leveled so you can do pretty much everything at a low level, even being naked with an iron dagger and starter spells. You can also bash down locks or blow them open with a spell with no failure rate. There are no sleep attacks at this level.
Easy Mode: To be honest like vanilla Skyrim on moderate difficulty yep... And still having the psychic clairvoyant arrow guiding you around. Again there is no durability system, magicka comes back quickly like in Skyrim, diseases aren't that big of a deal, and enemies are leveled. In easy mode, iron weapons, and the starter spells aren't as effective as they are in Story mode, and a starting out character is a bit more vulnerable. Though you have to use things like Ondusi's Door Opener or lock picking to get through doors... If you try to bash something open it has a lower chance of working.
You can be sleep attacked but never in cities, and the enemies are always weak.
Moderate mode: This would be highly similar to Morrowind, where yep, eventually the challenge of combat pretty much goes away cause you become so powerful... And early on you're like a miniature Mudcrab with needle thin claws made of tissue paper. Durability exists now, a lot of enemies are not leveled, starter spells and iron weapons won't be good enough for long, everything made from smithing is much weaker than anything of Dwemer or higher quality, and the common materials- IE, Iron, Steel, regular wood and so fourth are a lot weaker. Diseases are also more of a problem, making you much much weaker even on an endgame character.
If you try to bash something open... You could damage what's inside, or if it's a door you could accidentally hurt innocents on the other side. So lockpicking and lockpicking spells are more important. Your magicka also regenerates a bit slower.
Durability is a thing now, and magicka regenerates much much slower... A rate of about 2 magicka every 60 seconds. If you enter a high arcane energy pool which are scattered across the world, you can make it recharge much faster, but these energy pools will be away from most enemy encounters, and being in the pools will make you more vulnerable to magical damage as well. You also now have to have a journal guide you around and read it to find your away around, no more psychic guiding arrows.
You could be sleep attacked by a Dremora Lord out in the wilderness at level one albeit it's unlikely... Inside of cities you can be sleep attacked but only by rats and spiders- barring quest events perhaps. In Moderate and harder modes, health potions heal over time.
Hard mode: This would be again similar to Morrowind's scaling system only you wouldn't be so powerful end game... End game would be harder than vanilla Morrowind, as character stats wouldn't be enough on it's own to make everything easy.
Until you have a 100 destruction skill with spells to match you will struggle in combat as a destruction mage, and as a more regular physical combatant until you have gear that is of Dwarven or higher quality you will struggle a lot... Even with very high strength and health. In full Dwarven or with enough powerful spells and enchantments at your disposable you will finally stand a chance... Being about as strong as a level 10-15 character in Morrowind that has decent combat abilities... Be they stealth, magic or direct combatant warrior-ish.
Although there will be an animation warning to get out of dodge- some endgame enemies- who have godlike power will be able to kill you in three hits, unless you sacrifice magicka and stamina to get the highest health possible in which case it's four hits.
Sleep attacks are still a thing, but now the chances of being sleep attacked by powerful enemies are higher... And more numerous amounts of weaker enemies may attack you in your sleep.
Challenge mode: In challenge mode, you have to be pretty much absolutely metagaming just to make it through, you go from being like that mudcrab until your stats, abilities, character power, and skill as a player are nearly maxed out. Unlike in Skyrim, where stacking enchanting, smithing and all that, makes you able to casually walk through everything with relative ease so long as you have decent combat skills as a player, this time you need all that just to stand a chance. The game would have the difficulty I'd say, of an Ocarina Of Time boss fight, and you'd need all that metagaming just to stand a chance. In Challenge mode, Daedric artifacts, and top tier gear will be pretty much essential just to get through the game.
Some enemies will be able to kill you in one hit unless you stack your health stat as high as possible- in which case it's a two hit kill, and this move will be significantly faster than in Normal mode so it's harder to predict. Durability is a thing, and stuff wears out faster than on normal mode, magicka regenerates even slower with it being 1 magicka per 120 seconds. and being at a magicka energy pool makes you take three times more damage rather than double damage in normal mode. Diseases if they go untreated for too long, can also become fatal now. And again you also now have to have a journal guide you around and read it to find your away around, no more psychic guiding arrows.
Sleep attacks are more likely than the other modes, high level enemies are more likely to sneak attack you, and sometimes even Dremora Lords, Golden Saints and stuff can even attack you while sleeping in cities... At a low level too.
Maybe programming it all in would make things far too complicated and somehow negatively effecting modding potential or something for all I know, but I think it'd be way better than the difficulty slider in every TES game to date. And the higher the difficulty level, the weaker common materials, and the starter spells are in comparison to who you fight... So Dwarven, Daedric, Glass, and Daedric Artifacts don't have their stats nerfed, but iron, steel and so forth do in higher difficulties. Making high quality gear essential for success in harder difficulties.
I'd really like a difficulty mode where it's pretty much impossible to succeed, wearing steel armor and dual wielding iron daggers. As I personally like the challenge of struggling to survive, on a scavenger hunt basically... And then I only stand a chance when I have the gear or spells required to defend myself. In vanilla moderate difficulty Skyrim I could even defeat Sabrecats quite reliably around level 5-7, by just utilizing decent combat skills as a player... With just like... Steel weapons, or kiting the Sabrecat around while using spells. And I wish I had to be almost level 20, with Dwarven gear, or 90 skill in destruction or conjuration just to stand a chance. I think at least in Skyrim for instance the vanilla difficulty with no mods and stuff, would be better as Easy difficulty- and easy difficulty would be recmmended to new players, and Moderate difficulty would be tougher.
Looking at the difficulty between various TES games I played... Daggerfall seems to have the hardest difficulty starting out, Morrowind the second hardest... And Skyrim a very very very very distance third... Oblivion it was the easiest starting out. But then in Skyrim it felt like the main character grew in power too quickly. Like in Skyrim gains in power throughought say 5 levels, should've taken 20 or 30 levels I feel.
I think one of the main issues is, it's too easy starting out in Oblivion and Skyrim in Moderate difficulty... Making endgame feel less rewarding. And the other issue is, for people who want the thing to remain challenging the whole time through, they get bored even in Daggerfall and Morrowind when nothing is challenging anymore... Probably because there not being much of a Hard or Challenge difficulty being optional by default.