To answer this question, I read a few lines above lines 38 since that was what led to "moral imagination." So basically, moral imagination is required for people to "grasp the development of characters, to tangle with heightening moral crises, and to engage oneself with the story not as one's own but nevertheless as something recognizable and worthy of attention." And we are looking for an answer choice that represents this "moral imagination."
(B) - the part about "identifying oneself with one side or another in such controversies" goes against the notion of "to engage oneself with the story NOT as one's own", so it does not accurately represent "moral imagination"
(D) - the part about "ability to understand personal aspects of ethically significant situations EVEN IF one is NOT a direct participant and to empathize with those involved in them" is compatible with the idea of "to engage oneself with the story NOT as one's own but nevertheless as something recognizable and WORTHY of attention" so is more or less an accurate representation of "moral imagination."
Hope this helps!