That IoControl error means that your copy of Shenmue has been patched, probably to make it self-bootable.
ChanKast doesn't have a workaround for that IoControl error, but ChanKastEx does.
Get ChanKastEx from here:
http://chankex.esmartdesign.com/install.html
Here's the way to fix that IoControl error.
After installing and setting up ChanKastEx, go to Configure > Advanced > Don't report CD errors.
However, your better off with NullDC, if you can get it working.
Either that or download a copy of Shenmue that hasn't been patched, like the one on Sprung's FTP.