The only reason your laptop is unable to read the CD, would be a faulty CD or a faulty CD drive. All CD's use a filesystem called CDFS, so it matters not what version of windows you run. You CAN upgrade your ME machine to Windows XP, but as TB has said, it is unadvisable. It is best to install Windows XP on the laptop from scratch.
Before you get started, you will need to gather an exact list of what hardware your laptop is using, in order to get the correct Windows XP drivers for it. Usually these are included on the original installation CD that came with the laptop, but as the it seems quite old, this may not be the case. Refer to your original manual for the list of hardware it runs.
Best way to upgrade: Insert the official Windows XP installation CD-ROM into your laptop, and reboot it. Before Windows ME loads up again, it will ask you to "Press any key to boot from CD". Press the RETURN key at this point - most vendors still haven't put an 'any' key on their keyboards yet

Windows XP setup will load up after scanning your laptop. Follow the instructions through, and eventually you should be able to reformat your laptop if the setup program deems it capable of running XP. Once thats done, you can sit back while XP installs itself. It will pause at several intervals as it needs some minor user input (like selecting languages and inputting the CD Key etc). After about an hour to an hour and a half, you should be looking at your nice new Windows XP desktop. All you need to do here is install the hardware drivers that you should have downloaded/found, as per paragraph above.
If you are unable to install Windows XP, I recommend installing Windows 98SE or Windows 2000 rather than Windows ME. It is a much more stable operating system and a lot faster. Windows ME was one of Microsoft's biggest mistakes. You can get Windows 98SE anywhere, as MS no longer support it, and copied/pirated versions no longer concern them.