Considering how height-based terrain works, there's no reason why Daggerfall couldn't have supported hills, mountains, valleys, and other varied terrain. I suspect the problem was that pre-computing such elaborate terrain was beyond the means of Bethesda for one reason or another. Storing elaborate terrain would not have required much (if any) additional storage space. But calculating plausible terrain for a country-sized landmass might have been too much for them. Simply applying varying levels of jitter depending on the terrain type would have been a lot easier to process and test than trying to pull off varied terrain types that all need to level out properly to accommodate the flat city tiles. I bet with an improved tool to generate the terrain in the first place, the engine used for Daggerfall could have rendered complex terrain with no changes to the engine. Future Shock and Skynet are evidence of that. They used the same engine, and terrain in both of those games was a lot more varied than that of Daggerfall.
My personal theory is that they had planned it but since the game was rushed to market it was one of the features that suffered. There's at least one pre-release screenshot of an elaborate mansion carved into a hillside, and another of an Argonian on the ocean floor (although I haven't seen this one in years). I know it was possible, but Bethesda was probably worried about rushing Daggerfall to market before Betrayal at Antara (which, by the way, almost no one seems to remember; Krondor was so much better). It svcks but I kind of understand the situation they were in. Arena was released in the spring and sales probably suffered as a result. If they would've worked on Daggerfall for much longer it probably would've appeared outdated; 1996 was the same year Quake came out.
All speculation, though. No one will really know for sure unless one of the original devs chimes in. Speaking of which, I was thinking of trying to get a hold of Tedders and asking him what he thought of this. Has anyone seen him around?