What is the theme of the demo level?
A rolling English countryside, with trees, rocks, and grass as far as the eye can see. Maybe have some odd rock rock formations that look suspiciously like loops here and there. Plenty of space to run around in, and using the natural environment as a physics playground. Possibly even a lake to either run on top of or take a dip in. If the guys doing assets have time, we could put in some houses, farmland, etc. Something large in scale, but at the same time, can be easily designed, modeled and modified.
Other potential ideas include: the remains of a castle scattered about the landscape that forms some of the more over-the-top structures. Some streams along with the lake, and maybe even have Little Planet in the sky as a Sonic CD reference.
The main reason for this theme is because creating such a landscape is relatively easy compared to other themes - the terrain is easy enough to create and edit, allowing for a basic environement for Sonic to run around in, and then there's trees, rocks and grass, not that difficult to make. And we can add other things once we have the basic assets created, for additional content.
What would make the demo look pretty?
The huge landscape that extends as far as the eye can see, moving clouds, lots of grass, lighting... Large-scale is a good way to make a level look interesting.
What hardware should it be targeted for?
Mid-end hardware, with graphics options for higher-end hardware.
What gameplay style should it follow?
A large enough environment could accommodate any style, but my personal preference is Classic-based 3D gameplay, which takes full advantage of the landscape. But we can have 'missions' that change the gameplay style to demonstrate what we want.
Hell, since Black Knight did that whole countryside thing first, we could even include the option to give Sonic a sword and swing it around. Might be a good way to show off how the engine could do even more than just 'classic' and 'modern'.
How can we showcase specific feature sets with this demo?
Well, with good level design, basically. Depends on what said feature sets are.