I am glad there is a format war to keep quality up, but it also has this dissadvantage. They are encoding to the least common denomonator.
That might be true, but not the way you think.
Blu-ray is currently the "least common denominator" as you put it. BD50 is not widely available so the vast majority of BD discs are limited to 25 GB. Also, no advanced audio codec support is being used to any great extend on BD because not all hardware supports it. Also, interactivity is limited on BD because the hardware does not always support it.
Lastly, it should be noted that we have been told Warner is not encoding for limitations. HD DVD encodes are for the HD DVD format, meaning 30 GB with the total bandwidth limites of that format. If something does not fit on 25 GB, Warner is either leaving features off, releasing on BD50 when possible (The Searchers), or not putting things on BD at all (all IME titles).
How awesome would the Warner releases be if they tool full advantage of the Blu-Ray data rates and disc size?
I suppose they could make the BDs just as awesome as the HD DVDs.