This is awesome. LLM-powered NPCs is one thing I'm most excited about in the future of gaming. Characters repeating the same scripted dialog over and over again is one of the biggest immersion breakers.
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There could probably be cool uses but I don't think it will be a pure "upgrade" as the repeating dialog is kind of a feature honestly.
We'll have to see how it pans out xD
Current video games are designed around streamlining content. As a player, your job is to extract all content from an area before going to the next. That's why most areas are designed as linear corridors so that there is a straightforward progression, and most NPCs interactions are meant to offer something meaningful so as to not waste the player's time.
But imagine if interaction with NPCs wasn't just a content delivery mechanism, but instead could sometimes be rewarding, sometimes useless, dynamically adjusted in how you interact with the world in non-predictable ways.
The player would just waste their time in their usual approach of canvasing each new area, which would become unsustainable. There would be no reliable way of ensuring you've extracted all the content. All he/she could do is roam around more naturally, hoping the glimpses they catch are engaging and interesting enough.
Maybe a new player skill would be to be able to identify the genuine threads of exciting content, be it designed or emergent, within the noise of an AI-generated world.
Realistically though, how do you build an exciting player experience with this framework? A starting point might be to approach it as something more akin to LARP or improvisation theater, you'd give each NPC and player a role they need to fulfill. Whether players actually enjoy this is another thing entirely.