I think this would be the perfect solution. I (strangely) liked getting a message in Morrowind telling me I broke the main quest by killing an npc. I had the option then to either reload, or keep playing and forget the main quest. It didn't give you a message for killing other faction NPCs, but that's a reasonable price for wantonly killing people in your game. You get the freedom to be a stone-cold killer, but it comes with consequences (other than a fairly low bounty).
That said, I (personally) hate when dragons torch a bunch of townsfolk. Especially when they blatantly ignore me to do it. I don't particularly like being excluded from quests through no fault of my own. Changing all the essential NPCs to a semi-essential state that allows me to kill them, and no one else, would be awesome. I generally don't play a hair-trigger killer, but trying to clear an army camp with unkillable officers is rather silly.
You can actually still beat the Morrowind Mainquest even if you killed a MQ-NPC... Just go get Keening and Sunder then kill the Heart, ignoring the damage you are getting. After you did that, everything else will automaticly triggered (Example: You can then go straight to Vivec and get Wraithguard from him, even if you never knew he had it)
~Edit~
Btw, the best Solution would be to remove the Essential from the NPCs after you did ALL Non-Random Quests for them. (Like you can kill Delphine and Esbern after the Mainquest since they are no longer needed for any real quests) - This is because you can accidentally kill people specially with magic; my Wall of Storm spell killed that Meeko Dog follower on accident =(
Also, they should keep some followers, like Derkeethus, Essential because I don't want my follower to die because of me moving far ahead of them =(