Testing based on the yaml files shared by you, I don't have the same error and the pipeline works fine.

azure-pipelines.yml:

trigger:
- none

pool:
  vmImage: ubuntu-latest

extends:
  template: pipeline.yml
  parameters:
    DefaultSettings:
      Service1:
        Setting1: Value1
        Setting2: Value2
      Service2:
        Setting1: Value1

    Environments:
      Development:
        Settings:
          Service1:
            Setting2: DevelopmentValue2
          Service2:
            Setting1: DevelopmentValue1
      Test:
        Settings:
          Service2:
            Setting1: TestValue1

pipeline.yml:

parameters:
- name: DefaultSettings
  type: object
  default: []
- name: Environments
  type: object
  default: []

stages:
- stage: Pipeline
  jobs:
  - job: job
    steps:
    - script: |
        echo "ENVIRONMENTS: ${ENVIRONMENTS}"
        echo "DEFAULTSETTINGS: ${DEFAULTSETTINGS}"
      env:
        ENVIRONMENTS: ${{ convertToJson(parameters.Environments) }}
        DEFAULTSETTINGS: ${{ convertToJson(parameters.DefaultSettings) }}

- ${{ each environment in parameters.Environments }}:
  - template: environment.yml
    parameters:
      Environment: ${{ environment.Value }}
      DefaultSettings: ${{ parameters.DefaultSettings }}

environment.yml:

parameters:
- name: Environment
  type: object
  default: []
- name: DefaultSettings
  type: object
  default: []

stages:
- stage:
  jobs:
  - job: job
    steps:
    - script: |
        echo "ENVIRONMENT: ${ENVIRONMENT}"
        echo "DEFAULTSETTINGS: ${DEFAULTSETTINGS}"
      env:
        ENVIRONMENT: ${{ convertToJson(parameters.Environment) }}
        DEFAULTSETTINGS: ${{ convertToJson(parameters.DefaultSettings) }}


- template: environment-stages.yml
  parameters:
    Settings:
      ${{ each service in parameters.DefaultSettings }}:
        ${{ service.Key }}:
          ${{ each setting in service.Value }}:
            ${{ setting.Key }}: ${{ coalesce(parameters.Environment.Settings[service.Key][setting.Key], setting.Value) }}

environment-stages.yml:

parameters:
- name: Settings
  type: object
  default: []

stages:
- stage: 
  jobs:
  - job: job
    steps:
    - script: |
        echo "Settings: ${SETTINGS}"
      env:
        SETTINGS: ${{ convertToJson(parameters.Settings) }}

Result: