Carl,
Sending an Email when an error occurs is pretty much the only way to do error handling with an Image output, and you can configure that in the Preferences under "PlanetPress Image 1".
Besides that, the problem is that the "On Error" tab doesn't work with Image Outputs, since Image is a separate service, and so Workflow is "unaware" of what happens to Image. If you want to use the On Error, use Digital Action instead of PlanetPress Image, which is the same thing, except Digital Action runs in the Workflow service, not a separate service. (you can then use a Send Email output if you're also using Image for the emailing)
Regards,
Raphaël Lalonde Lefebvre