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I've set an issue type to be above Epic, as this is how we would like to group Epics. I'm confused why Capability has a 2 against it? Does that have any impact or is the hierarchy purely the order from top to bottom?
This is just to show the hierarchy level from top down. If you create another level on top of Capability, you would get no 3 assigned against it. So, basically issuetype in #2 is parent of issuetype defined in #1, issuetype in #3 is parent of issuetype defined in #2.
It has no other impact.
I'm not sure whether this will match your full use-case but you might want to check out my Collections app, which allows you to create multi-level Issue hierarchies: