This is the Setsuna backstory episode. Setsuna brings Towa to a forest deep in the mountains and tells her about the secret village, protected by a barrier, that served as a haven for half-demon children with no homes or families to return to. She tells Towa about what it was like to grow up there, and about what happened shortly before she finally left.
First of all, just the fact of Setsuna being emotionally open and honest with Towa, or anyone for that matter, shows how far she’s come as a character. It also shows how far she and Towa have come. It also finally fleshes out how Setsuna and Miroku know each other, which will become important going forward. I think it’s a solid episode and lays a lot of groundwork for the final few episodes. However, it does add to the weirdness of episode 12; because we know now, that Setsuna had known for at least a few years that half-demons occasionally lose their powers. It doesn’t make sense that she would know that at 10 or 11 years old, and not realize what was happening with Towa when it happened to her just a few years later.