It's very simple. The Observer's music editor looks at the CD and uses this test:

Add 2 points for each band member with a beard
Add 2 points if the singer has a regional accent (other than London)
Add 2 points for the following instruments: acoustic guitar, double bass, smaller-than-usual drum kit, "quirky" keyboards, stylophone etc
Add 5 points for any of the following instruments: fiddle, banjo, mandolin, ukulele, accordion, harmonica, melodica, flute, whistle, glockenspiel (Note: ability to play them competently counts less than novelty value)

If it scores 10 points or more it goes in the "folk" section.