I think whoever is responsible for the Delay Repay software has completely dropped the ball here.
The govt's policy, as written, does not allow using the alternative leg it's proposing.
I agree, although it is useful, as the claimant, to be able to see the reasoning behind the TOC's decision.
I recently sent in a paper claim to GWR for a journey from Maidenhead to Paddington. I didn't intend to, and didn't, travel anywhere else by rail after arriving at Paddington. They've entered my journey details onto their online portal and have hallucinated additional journey legs between Paddington and Waterloo and between Waterloo and Feltham, seemingly for no other reason than that my inboundary Z1-6 Travelcard season ticket happened to be issued from Feltham to Z1-6. But at the same time, they've also claimed that my intended train from Maidenhead to Paddington isn't in the timetable (it was the Tuesday after the fire just outside Paddington and the Didcot Parkway to Paddington services were curtailed to run Didcot Parkway to Reading, but they were still shown as cancellations between Reading and Paddington on journey planners and on screens at stations). This makes it difficult to know where to begin as one doesn't quite know which bits of nonsense to focus on when appealing.
At least in the OP's case you can see that they've identified an alternative service for which the OP's ticket was not valid, which is a very clear point of appeal. Even somebody working for Northern really ought to be able to grasp it.
As a more general point, even if the system took TOC and route restrictions into account when identifying the first alternative service the passenger could have taken, it seems to me to be unsatisfactory to assume the passenger did in fact take that service. It's the same thinking that gives us microeconomics - the individual is assumed to be not only rational but all-knowing.
The passenger ought to be able to say which train they took and if the TOC wants to base its decision on compensation on a quicker journey that should hypothetically have been possible, it needs to be sure that it was the passenger's choice or, at the very least, the passenger's fault that they didn't make that quicker journey. The test is whether the delay was caused by a delayed train or trains; if it was, compensation is owed based on the actual delay.