What this query does to create comma delimited list SQL Server?

The simplest way of explaining it is to look at how FOR XML PATH works for actual XML. Imagine a simple table Employee:

EmployeeID      Name
1               John Smith
2               Jane Doe

You could use

SELECT  EmployeeID, Name
FROM    emp.Employee
FOR XML PATH ('Employee')

This would create XML as follows

<Employee>
    <EmployeeID>1</EmployeeID>
    <Name>John Smith</Name>
</Employee>
<Employee>
    <EmployeeID>2</EmployeeID>
    <Name>Jane Doe</Name>
</Employee>

Removing the ‘Employee’ from PATH removes the outer xml tags so this query:

SELECT  Name
FROM    Employee
FOR XML PATH ('')

Would create

    <Name>John Smith</Name>
    <Name>Jane Doe</Name>

What you are then doing is not ideal, the column name ‘data()’ forces an sql error because it is trying to create an xml tag which is not a legal tag, so the following error is generated:

Column name ‘Data()’ contains an invalid XML identifier as required by FOR XML; ‘(‘(0x0028) is the first character at fault.

The correlated subquery hides this error and just generates the XML with no tags:

SELECT  Name AS [Data()]
FROM    Employee
FOR XML PATH ('')

creates

John Smith Jane Doe

You are then replacing spaces with commas, fairly self explanatory…

If I were you I would adapt the query slightly:

SELECT  E1.deptno, 
        STUFF(( SELECT  ', ' + E2.ename 
                FROM    emp AS e2 
                WHERE   e1.deptno = e2.DEPTNO 
                FOR XML PATH('')
            ), 1, 2, '') 
FROM    EMP AS e1 
GROUP BY DEPTNO; 

Having no column alias will mean no xml tags are created, and adding the comma within the select query means any names with spaces in will not cause errors,STUFF will remove the first comma and space.

ADDENDUM

To elaborate on what KM has said in a comment, as this seems to be getting a few more views, the correct way to escape XML characters would be to use .value as follows:

SELECT  E1.deptno, 
        STUFF(( SELECT  ', ' + E2.ename 
                FROM    emp AS e2 
                WHERE   e1.deptno = e2.DEPTNO 
                FOR XML PATH(''), TYPE
            ).value('.', 'NVARCHAR(MAX)'), 1, 2, '') 
FROM    EMP AS e1 
GROUP BY DEPTNO;