Mike,
As per Greg’s response, it is not possible to set the encoding of the schema used by BizTalk internally, however you can control the encoding of the output message, although there is a gotcha – see http://www.modhul.com/2008/04/03/xmlassembler-targetcharset-property-error-in-biztalk-2006-2006-r2/ for more information.
Is your schema error in Visual Studio when you try and open the schema or at runtime in the Event Log?
Rgds, Nick.