Daggerfall's in-game world size wouldn't matter, since its randomly generated.
The dungeons and cities are static, and there's quite a few of them. But I don't think he meant the size of the game world.
The DF file size is 148mb, and a UMD can hold that+third party patch fixes.
The size of DF
zipped before install is 148MB. A full DF install is over 400MB. Still not big enough to fill a UMD, but again... probably not what he was talking about.
The issue with a game as big as Daggerfall isn't so much the amount of space that it takes up as it is the amount of issues that the stuff taking up that space implies. Daggerfall is a broken game where any number of things could easily go wrong (and quite a few of them do in the original version), which means that porting it is something that could easily lead to a lot of unforeseen issues in terms of bugs and glitches. More importantly, you seem to think that porting a game is a trivial kind of thing. It's not. The PSP architecture isn't even remotely similar to a DOS computer, and its OS is nothing like DOS. An emulator wouldn't be fast enough to run Daggerfall on it. This means that porting it would be
extremely difficult, to the point where it might be more practical to just redo the entire game engine (which they definitely aren't going to do, because putting those kinds of resources into remaking a game that's available for free when they could just make an entirely new game isn't really something that syncs up with their "we don't do work on old games" comments). And of course, even if they did that the game could still easily end up completely broken.
Porting a game isn't a cut-and-paste job with a bit of tweaks here and there, particularly when it involves porting from something like a DOS PC to the PSP. It would take a significant amount of effort, and any number of things could go wrong with it.