When debugging using the Azure Compute Emulator and the Web Role set to use IIS Express, the WindowsAzureDebugger.exe application tries to launch IIS Express. Unfortunately, because it's going over WCF remoting, there appears to be a limit on the size of the ProcessStartupInfo class that is sent when launching the debugger. In the WaIISHost.log file created by the compute emulator, you'll see messages saying there are issues deserializing this object. I have confirmed that if you make the environment variables small enough, it will work as expected.
Azure SDK 1.8 (October 2012)