<PAGE>

                                                                    EXHIBIT 10.6

        PHASE II DEVELOPMENT AND PHASE III FEASIBILITY STUDY AGREEMENT

          This DEVELOPMENT AGREEMENT ("Agreement") is effective as of
January 22, 1999, ("Effective Date") by and between Active Power, 11525
Stonehollow Drive, Suite 135, Austin, Texas 78758  ("ACTIVE POWER") and
Caterpillar Inc., 100 N.E. Adams Street, Peoria, Illinois  61629-6490
("CATERPILLAR").

          1.   DEFINITIONS
               -----------

          For purposes of this AGREEMENT, the following definitions shall apply:

               a)   "AFFILIATE" means any company, corporation, partnership or
other business entity which is more than fifty percent (50%) or more owned,
directly or indirectly, by a party to this AGREEMENT.

               b)   "BACKGROUND INTELLECTUAL PROPERTY" shall be all INTELLECTUAL
PROPERTY incorporated into the PHASE II PRODUCT other than that which is defined
as PROGRAM INTELLECTUAL PROPERTY.

               c)   "FIELD OF USE" shall mean earth-moving equipment,
construction equipment, mining equipment, forestry equipment, engines, engine
generator sets, agricultural equipment, paving equipment, components for all
such equipment and all reasonable extensions thereof which are mutually agreed
in writing by the parties hereto.

               d)   "INTELLECTUAL PROPERTY" includes, without limitation,
inventions, whether or not patentable, copyrights, computer software and
accompanying documentation, specifications, know how and original works of
authorship. INTELLECTUAL PROPERTY includes PROPRIETARY INFORMATION.

               e)   "PROGRAM INTELLECTUAL PROPERTY" means INTELLECTUAL PROPERTY
that is  created, made, conceived or reduced to practice in performance of work
under the PROGRAM with respect to UPS electronics (identified as such in Exhibit
E) or UPS packaging.

               f)   "PROGRAM" shall mean the efforts of CATERPILLAR or ACTIVE
POWER to develop PHASE II PRODUCTS.

          2.   PROGRAM
               -------

          CATERPILLAR and ACTIVE POWER have agreed to a PHASE I program under a
separate agreement governing the purchase of certain PHASE I products.  This
Agreement governs Phase II development and preliminary Phase III discussions.
Notwithstanding anything contained in this Agreement and subject to the
restrictions in the PHASE I Purchase Agreement, nothing contained herein shall
preclude ACTIVE POWER from selling or otherwise disposing of ACTIVE POWER'S
CleanSource flywheel energy storage system.

               a)   PHASE II

                    (i)  The parties shall cooperate to develop a PHASE II
PRODUCT which shall include an industrial duty uninterruptible power supply
("UPS") and a CleanSource flywheel. The PHASE II PRODUCT specification and
requirements are detailed in Exhibit A ("Specifications").

                                       1
<PAGE>

                    (ii)   The parties will cooperate with one another to
design, develop and test the PHASE II PRODUCT for possible use with CATERPILLAR
generator sets. ACTIVE POWER will make one prototype that conforms with the
Specifications. If the parties mutually agree on any changes to the
Specifications during the development process, such changes shall be
incorporated into the Specifications and be attached to,and become part of, this
Agreement. The parties will test this prototype, at a mutually, reasonably
agreed upon site, for compliance with the Specifications (except for the
Specification relating to reliability target) stated in Exhibit A. Each party
will document and report to the other party the results of such tests performed
on such prototype together with any comments concerning design changes, further
development, and the like. CATERPILLAR will accept or reject the PHASE II
PRODUCT prototype within thirty (30) calendar days after testing begins at the
site selected by CATERPILLAR (however, if CATERPILLAR fails to indicate a
testing location within sixty (60) days after ACTIVE POWER has completed
Milestone 2 (as set forth in Exhibit C), the testing site shall be ACTIVE
POWER's site in Austin Texas); failure to give notice of acceptance or rejection
will constitute acceptance. CATERPILLAR may reject the PHASE II PRODUCT only if
it fails in some respect to meet the Specifications (except for the
Specification relating to reliability target) stated in Exhibit A. If
CATERPILLAR properly rejects the PHASE II PRODUCT, ACTIVE POWER may correct the
failures and when it believes that it has made the necessary corrections and has
notified CATERPILLAR, the parties will again test the PHASE II prototype and the
acceptance/rejection/correction provisions above shall be reapplied until the
PHASE II PRODUCT is accepted; provided, however, if a correction to a
deliverable that is rejected by CATERPILLAR for failure to meet a Specification
(except for the Specification relating to reliability target) set forth in
Exhibit A is not accepted, Caterpillar may terminate this Agreement. The day on
which CATERPILLAR accepts the PHASE II PRODUCT shall be deemed the "Acceptance
Date". After the Acceptance Date, CATERPILLAR may purchase additional prototypes
at a price per prototype defined by the pricing for Phase II Product in Exhibit
B. Any prototypes shall be provided to CATERPILLAR on an "AS IS" basis.

                    (iii)  Within ninety (90) days following the Acceptance
Date, CATERPILLAR shall have the option of purchasing such PHASE II PRODUCTS
pursuant to the provisions of the Phase II Purchase Agreement Terms and
Conditions ("Phase II Purchase Option") as specified in Exhibit B hereto. In the
event of conflict between this Agreement and the Phase II Purchase Agreement
Terms and Conditions, this Agreement shall control. Caterpillar may exercise
such Phase II Purchase Option by providing written notice to Active Power of
such exercise within the aforesaid 90 day period. ACTIVE POWER will cooperate
with CATERPILLAR during reliability testing to meet the reliability targets.

               b)   PHASE III

                    (i)    CATERPILLAR and ACTIVE POWER will negotiate
reasonably and in good faith towards a PHASE III development program ("PHASE III
PROGRAM"), which presently contemplates the activities specified below in
paragraph 2(b)(iii).

                    (ii)   CATERPILLAR and ACTIVE POWER may agree to jointly
fund any PHASE III PROGRAM.

                    (iii)  The PHASE III PROGRAM development will include a
jointly completed feasibility study [****] that is based on the PHASE II PROGRAM
developments, ACTIVE POWER's flywheel technology, and CATERPILLAR's knowledge of
the generator set market. The parties will also explore other opportunities for
application of the PHASE II PRODUCT and opportunities for further joint
development efforts to expand the PHASE II PRODUCT's capabilities. The study
will identify the scope

                                       2

**Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.**
<PAGE>

of the market opportunity, required resources, technical risk, and an initial
application. [****] It is envisioned that the feasibility study will provide
ACTIVE POWER and CATERPILLAR with necessary information to complete a long-term
[****] alliance agreement.

          3.   PHASE II COSTS
               --------------

               a)   Unless otherwise stated in this Agreement or later mutually
agreed to in writing specifically referencing this Agreement, each party will
bear its own costs incurred in the PROGRAM.

               b)   Caterpillar agrees to pay Active Power for co-ownership of
PROGRAM INTELLECTUAL PROPERTY the sum of $5,000,000 (five million dollars). The
payments shall be made in installments, each installment being due and payable
upon the objective satisfaction of each of the five milestones in the payment
schedule listed in Exhibit C ("Payment Milestones"). Other than the payments
specified above, Caterpillar shall not be responsible for any other payments or
funding, and Active Power shall bear all its costs for participating in this
Program, or any part thereof. Caterpillar shall bear its own costs for
participating in this program, or any part thereof.

               c)   Upon receipt of ACTIVE POWER'S correct itemized invoice(s)
and after objective satisfaction of each Milestone, CATERPILLAR will pay ACTIVE
POWER in accordance with such invoice.

          4.   CONFIDENTIALITY
               ---------------

               a)   In connection with work under this Agreement, a party
("TRANSMITTING PARTY") may deliver PROPRIETARY INFORMATION relating directly to
the PHASE II or PHASE III development to the other party ("RECEIVING PARTY").
The RECEIVING PARTY may not use the PROPRIETARY INFORMATION except for work
performed according to this Agreement, will protect the confidentiality of the
PROPRIETARY INFORMATION with at least the same degree of care as it protects its
own confidential information and will not disclose any such PROPRIETARY
INFORMATION, without the express written consent of the TRANSMITTING PARTY.
"PROPRIETARY INFORMATION" includes any process, system, formula, pattern, model,
device compilation, or other information:  (i) not known by the RECEIVING PARTY
prior to this Agreement or known by the RECEIVING PARTY prior to this Agreement
but having restriction on its use or disclosure; and (ii) not generally known by
others (unless so know through some fault of the RECEIVING PARTY).  PROPRIETARY
INFORMATION does not include knowledge, skills or information which is generally
known in ACTIVE POWER's or CATERPILLAR's trade or profession.

               b)   Each party agrees that it will neither (i) disclose to the
other party or any of its employees information in confidence belonging to a
third party; nor (ii) knowingly in the performance of the work hereunder produce
anything that embodies information under confidential restriction, or is covered
by a patent, patent application, copyright, trade secret, or other intellectual
property right owned by a third party.

               c)   Nothing in this Agreement shall be construed as preventing
either party from independent development, provided that PROPRIETARY INFORMATION
is handled in accordance with paragraph 4(a).

               d)   Should the RECEIVING PARTY be required to disclose
PROPRIETARY INFORMATION by governmental or judicial order, the RECEIVING PARTY
will give the TRANSMITTING PARTY prompt notice of any such order and will comply
with any protective order imposed on such disclosure.


                                       3

**Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.**
<PAGE>

          5.   INTELLECTUAL PROPERTY
               ---------------------

               a)   BACKGROUND INTELLECTUAL PROPERTY shall remain the property
of the party who created, made, conceived and reduced it to practice.

               b)   All PROGRAM INTELLECTUAL PROPERTY shall be jointly owned by
the parties and may be exploited and/or nonexclusively licensed by either party
without further consent or accounting to the other party.  With respect to all
rights and ownership in such PROGRAM INTELLECTUAL PROPERTY, the parties will
mutually discuss whether to obtain or maintain such rights, including without
limitation, any patents, trademarks, copyrights, trade secrets, CONFIDENTIAL
INFORMATION, and any other proprietary rights therein, and if one refuses to
take any such joint action requested by the other, the other may proceed at its
own expense; no such action will change the foregoing ownership provision.  A
party will execute all documents the other may request for such purposes and to
otherwise assist the other (at the other's expense) for such purposes.

               c)   Each of CATERPILLAR and ACTIVE POWER grant to the other
party an irrevocable, perpetual, nonexclusive, worldwide, royalty free license
(including the right to sublicense to such other party's Affiliates) to make,
have made, use, sell and otherwise exploit during and/or after the term of this
Agreement any modifications, improvements, inventions, know how, ideas or
suggestions made with respect to the other party's Proprietary Information by
such party's employees who have had access to such Proprietary Information.  If
something ceases to be considered Proprietary Information, licenses granted with
respect thereto while such information was deemed Proprietary Information, will
be unaffected.

               d)   Except as provided in this Agreement or the Exhibits,
nothing in this Agreement shall be construed as a grant of, or agreement to
grant, to either party any licenses under intellectual property rights of the
other party, regardless of whether they are dominant of or subordinate to those
provided herein.

          6.   LICENSING JOINTLY OWNED INTELLECTUAL PROPERTY
               ---------------------------------------------

               a)   Unless otherwise agreed to by the parties, all licensing
revenues generated by licensing PROGRAM INTELLECTUAL PROPERTY to third parties
shall be retained by the licensor of such PROGRAM INTELLECTUAL PROPERTY.

               b)   In the event that one party chooses to enforce PROGRAM
INTELLECTUAL PROPERTY rights against a third party, the other party shall be
given the opportunity to join in such enforcement prior to its commencement and
in the event the other party chooses to join, both parties shall equally share
all costs, including attorneys' fees and share equally all revenues generated by
the enforcement, including licensing fees, if any.  If the other party chooses
not to join such enforcement, such party shall nevertheless reasonably cooperate
with the one party in such enforcement (at the other party's expense), including
joining as a nominal party subject to indemnification by such party , but will
not be entitled to any proceeds of such enforcement activity.

          7.   NOTICES
               -------

          All notices and invoices pursuant to this Agreement shall reference
this Agreement and be given in writing to the respective party at its address
designated below or to such other address as may be substituted in writing by
that party to the other.  All notices shall be deemed to be fully given and
received if sent by registered or certified mail, postage prepaid, return
receipt requested.

                                       4

<PAGE>

     Notice to ACTIVE POWER:
     Active Power
     11525 Stonehollow Drive, Suite 135
     Austin, Texas 78758

     Notices to CATERPILLAR:                Invoices to CATERPILLAR:
     Caterpillar Inc.                       Attn:  Disbursements Div.
     Intellectual Property Department           LD235 Mailroom
     Attn:  Licensing Division              600 W. Washington Street
     100 N.E. Adams Street                  East Peoria, Illinois 61630
     Peoria, Illinois 61629-6490            Pontiac, Illinois 61764

          8.  INDEMNIFICATION
              ---------------

          Each party shall indemnify, defend and hold harmless the other party,
its directors, officers, employees and agents, from all third party (including a
party's employees) claims, demands, liabilities, loss, damage, and expense,
including costs, and reasonable litigation expenses and counsel fees incurred in
connection therewith, arising out of injury to or death of any person or damage
to property proximately caused by the indemnifying party's gross negligence or
willful acts or omissions which arise in connection with the performance of work
hereunder while the indemnifying party is on premises of the other party. Such
indemnity shall be provided subject to (a) prompt written notifications of any
and all such threats, claims, or proceedings related thereto and the other party
giving reasonable assistance to the indemnifying party in the defense thereof,
(b) the indemnifying party having sole control of the defense and all related
settlement negotiations, and (c) such indemnifications shall be limited in the
case of real or tangible property to the reduction in value or replacement cost
of such property.

          9.  WARRANTY
              --------

          Each party warrants its right to enter into this AGREEMENT.
Warranties for production units of PHASE II PRODUCTS shall be as set forth in
Exhibit B.  In addition, any hardware, software or firmware provided by ACTIVE
POWER to CATERPILLAR is warranted to accurately process properly formatted
date/time data (including, but not limited to, calculating, comparing, and
sequencing) from, into, and between the twentieth and twenty-first centuries,
and the years 1999 and 2000 and leap year calculations to the extent that other
hardware, software or firmware used in combination with the hardware, software
or firmware being provided by ACTIVE POWER, properly exchanges properly
formatted date/time data with it.

          10. TERM AND TERMINATION
              --------------------

              a)   This PROGRAM shall become effective on the Effective Date of
this Agreement and shall remain in effect unless terminated in writing by both
parties.

              b)   CATERPILLAR may terminate ACTIVE POWER's work under this
Agreement  by giving ACTIVE POWER ninety (90) days written notice in which event
ACTIVE POWER shall be (i) reimbursed only for work performed and expenses
reasonably incurred prior to receipt of such notice and (ii) entitled to
immediate payment of the amount associated with the next milestone. In no event
shall the total amount paid to ACTIVE POWER exceed the price agreed to herein.

               c)   Upon termination of this Agreement, Paragraphs 4, 5,6,7, 8,
9, 10, 11, 12, 13, and 14, of this Agreement shall survive.

               d)   If the Agreement is terminated and upon and in accordance
with the written reasonable request of either party (provided such written
request is given within a reasonable

                                       5

<PAGE>

period of time after such termination), but except for information covered by
the rights granted in Paragraph 5, the other party shall promptly return or
destroy any tangible information (including all copies thereof except as noted
below) provided under the PROGRAM by the requesting party. However the other
party's counsel may retain in a secure location one copy each of such tangible
information and use them only for ensuring compliance with the obligations of
Paragraph 5.

          11.  RELATIONSHIP
               ------------

          Nothing herein is to imply an agency, joint venture or partner
relationship between the parties.

          12.  ASSIGNMENT AND GOVERNING LAW
               ----------------------------

          Except to an entity that acquires all or substantially all the
business or assets of a party, this Agreement is not assignable by either party
without the written consent of the other party, which shall not be unreasonably
withheld, and will be governed by and construed in accordance with the laws of
the State of New York, without regard to the conflict of laws provisions
thereof.

          13.  ENTIRE UNDERSTANDING
               --------------------

          This Agreement and the Exhibits hereto constitute the entire agreement
and understanding between the parties with respect to the subject matters herein
and therein, and shall supersede and replace any conflicting terms and
conditions set forth in any purchase order, prior agreement, quotation,
proposal, correspondence, or oral discussion relating to the subject matter
hereof.  This Agreement may only be amended by a writing signed by both parties
which makes specific reference to the provision(s) of this Agreement being
modified.  Should any provision of this Agreement be held invalid, illegal, or
unenforceable, the validity of the remaining provisions shall not be affected by
such holding. This AGREEMENT shall be binding upon the heirs, successors, and/or
legal representatives of the parties.

          14.  Limitation of Liability
               -----------------------

          NEITHER PARTY SHALL BE LIABLE FOR (I) ANY SPECIAL, INCIDENTAL,
INDIRECT OR CONSEQUENTIAL DAMAGES ARISING OUT OF THE SUBJECT MATTER OF THIS
AGREEMENT OR (II) CATERPILLAR'S COST OF PROCUREMENT OF SUBSTITUTE GOODS OR
SERVICES.

          The parties have caused this Agreement to be signed in duplicate by
their duly authorized representatives on the Effective Date.

ACTIVE POWER, Inc.                       CATERPILLAR INC

By:      /s/                             By:       /s/
   ------------------------                 -----------------------------

Name:______________________              Name:___________________________

Title:_____________________              Title:__________________________

Date:______________________              Date:___________________________


                                       6

<PAGE>

EXHIBIT "A"

                      SPECIFICATIONS FOR PHASE II PRODUCT


     In the event that ACTIVE POWER has developed and includes a CS2 flywheel
  and associated components in the Prototype, then the Phase II Product shall
  comply with the following specification entitled CS2-UPS Specification,
  otherwise the Phase II Product shall comply with the following specification
  entitled CS1-UPS Specification.


                             CS1-UPS Specification
                                   12/14/98

                                  Definition

CS1-UPS is a line-interactive UPS that employs Active Power's first generation
DC to DC flywheel energy storage system (flywheel system described in US patent
5,731,645).

                    (i)   Ratings

  .  Maximum discharge time - 300 seconds
  .  Delivered energy - 3.0 MJ
  .  Maximum delivered power - 250KW for 12.5 seconds

                    (ii)  Input

  .  Input voltage - 480Vrms +10%/-20%
  .  Interface - 3 phase, 4 wire (3 phase plus neutral and ground)
  .  Input frequency - 45Hz - 66Hz
  .  Walk-in time - 1 second minimum, variable to up to 15 seconds

                    (iii) Output

  .  Nominal output voltage: 480Vrms, matched to utility input  +/- 5%
  .  Interface - 3 phase, 4 wire (3 phase plus neutral and ground)
  .  Output voltage regulation in Flywheel Mode:
       . +/- 5 % of input nominal, static balanced
       . +/- 5 % of input nominal, static asymmetrical
       . +/- 5 % of input nominal, within 80 ms following 100% step load
  .  Output voltage harmonic distortion:
       . 5% THD maximum and 3% any single harmonic with 100% linear load
       . 10% THD maximum with 100% non-linear load

                    (iv)  Recharge Time

  .  Recharge time - 2.5 minutes maximum
  .  Charge time from 0 RPM - 7.5 minutes maximum
  .  Adjustable to avoid overloading source
  .  Duty Cycle: 10% for 5 discharges

                    (v)    Standby Losses

         .  3% of rated power

                    (vi)   Temperature rating

     .   Start-up - 0 to +40C
     .   Operating - -20 to 40C
     .   Storage - -25 to +70C

                    (vii)  Humidity

                                       7

<PAGE>

     .   Relative humidity -  95%, non-condensing

                    (viii) Barometric Pressure

         .  Full rating to 3000  feet; reduced by 5% /1000ft above 4000ft

                    (ix)   Vibration

         .  5g  peak, 30ms pulse duration

                    (x)    Acoustical Noise

         .  70 dB, "A" weighting, at 3 feet from system

                    (xi)   Dimensions

         .  Height 79" maximum
         .  Width 43" maximum
         .  Depth 36" maximum

                    (xii)  Floor Loading

         .  325 lbs./sq. ft. maximum

                    (xiii) System Features

         .  Bi-directional Inverters
         .  Flywheel energy storage for standby power
         .  Adjustable load walk-in
         .  Internal self-diagnostics
         .  Fault event logging
         .  Preheat capability

                    (xiv)  Monitoring and Control

         .  Key switch for system control
         .  Local EPO (Emergency Power Off)
         .  LCD display - reports alarms & system state
         .  Monitor & alarms on critical components
         .  Programmable setup parameters
         .  External customer contacts (A-Type) dry contacts {six (6) input and
            six (6) output
         .  RS232 or RS485 Serial Connection
         .  Ethernet Interface

                    (xv)   System Options

         .  Automatic bypass
         .  Automatic restart following depletion of stored-energy and
            restoration of AC source
         .  Remote monitoring capability
         .  Internal modem
         .  Remote EPO (Emergency Power Off)
         .  Input voltage other than 480VAC using optional external transformer
            cabinet
         .  Output voltage other than 480VAC using optional external transformer
            cabinet

                    (xvi)  System Reliability

         The reliability target of .039 failures per 100 hours is to be met with
         a 75% confidence.

                                      8

<PAGE>


                                    [****]


                                       9

**Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.**


<PAGE>

                                    [****]


                                      10

**Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.**

<PAGE>

                                  EXHIBIT "B"

               PURCHASE OF PHASE II PRODUCT TERMS AND CONDITIONS

          The terms and conditions of the Phase II Purchase Agreement are
attached hereto and shall be incorporated herein by reference.


                                      11

<PAGE>

                          PHASE II PURCHASE AGREEMENT
                          ---------------------------

     1.  Products Covered by Agreement.  This Agreement concerns the purchase
and sale of the PHASE II PRODUCT  (hereinafter called "Product"), manufactured
to the Specifications.

     2.  Purchase and Sale of Product.  Subject to the terms and conditions of
this Agreement, Seller will, to the extent properly and accurately forecasted
and ordered by Buyer as provided in the next paragraph, use commercially
reasonable efforts to supply the Products to Buyer and Buyer agrees to purchase
ninety percent (90%) of Buyer's and its Affiliates ("Affiliate" means any
company of which Buyer holds a greater than fifty percent (50%) ownership
interest) requirements for an AC to AC flywheel-based UPS product for generator
set applications. Seller understands that Buyer makes no guarantee as to the
quantity of Product it will require, however, Buyer agrees that it will
undertake the Phase II activities set forth on Exhibit A ("Phase II
Activities").

     Buyer's initial forecasted annual requirements will be attached hereto as
Exhibit B as of the Effective Date of this Phase II Purchase Agreement. Buyer
agrees to update the annual forecast on a (Four (4) quarters) quarterly basis.
Such forecast of such requirements provided to Seller by Buyer shall be non-
binding and Seller acknowledges that it shall not be entitled to and shall not
rely on such forecasts/estimates as binding commitments unless they are
expressly stated as such by Buyer in writing.  Seller shall not be obligated to
supply Buyer with more than one hundred fifty percent (150%) of the initial
projection for a particular quarter, unless agreed to in writing.  Buyer's
forecasts and orders shall reflect its good-faith expectations of customer
demand and Buyer shall act in a commercially reasonable manner to schedule
orders to avoid creating production capacity problems for Seller.

     3.  Exclusive Caterpillar Rights.  For a period of five years from the
Effective Date of this Phase II Purchase Agreement, and provided this Phase II
Purchase Agreement has not been terminated, ACTIVE POWER agrees not to license
any PROGRAM INTELLECTUAL PROPERTY nor ACTIVE POWER's BACKGROUND INTELLECTUAL
PROPERTY that is solely developed for a PHASE II PRODUCT, to any entity set
forth in Exhibit C ("CATERPILLAR's Competitor List") that is manufacturing,
selling, using, or distributing equipment or components therefor within
CATERPILLAR's FIELD OF USE for the purposes of creating a product that is an AC
to AC flywheel-based UPS system.  Before the end of such five-year period,
ACTIVE POWER will, at CATERPILLAR's option, discuss the possibility of a
mutually agreeable extension of such FIELD OF USE exclusivity.  During such five
year period, if any, and provided this Agreement has not been terminated, ACTIVE
POWER shall, at CATERPILLAR's option and provided that CATERPILLAR meets the
Minimum Purchase Commitment as defined in Exhibit D, not sell PHASE II PRODUCTS,
to any entity on CATERPILLAR's Competitor List that is within CATERPILLAR's
FIELD OF USE.  However, nothing contained in this Agreement, shall restrict
ACTIVE POWER with respect to making, using, selling, marketing, licensing or
exploiting its flywheel energy storage systems or technologies.

     If, during any six (6) month period (as measured from the Effective Date of
this Agreement and every six (6) months thereafter), CATERPILLAR fails to meet
the agreed to Minimum Purchase Commitment, and does not, within the immediately
following six (6) month period or twelve (12) month period, make up the
difference and also meet the Minimum Purchase Commitments for that 6 or 12 month
period, then CATERPILLAR's exclusive rights shall be subject to renegotiation.
If Buyer exceeds the Minimum Purchase Commitment during any six (6) month
period, Buyer may carry such excess purchase(s) backwards and /or forward and
may apply such excess purchase(s) to Minimum Purchase Commitment(s) during the
immediately previous and/or subsequent six (6) month period(s).  If ACTIVE POWER
or CATERPILLAR is not satisfied with the results of such negotiation within
thirty (30) days,

                                      B-1
<PAGE>

then the exclusive rights set forth in this Agreement shall become non-exclusive
and the restrictions set forth in the above paragraph shall terminate.

     4.  Price Containment.  Both Seller and Buyer are committed to controlling
and reducing costs, and both recognize that effective cost control is of the
essence to this Agreement, While this Agreement is in effect, Seller will
maintain a cost control and reduction program with respect to Product, and will
review costs on a regular basis for progress toward the objective of maintaining
or reducing Seller's prices to Buyer.  A constant interaction between Buyer's
and Seller's engineering personnel is essential.  All documented mutually agreed
cost savings, through the efforts of Buyer or Seller, will be shared on a 50-50
basis.  Any cost savings gained without the efforts of Buyer and not mutually
agreed to in writing will be owned by Seller.  Any cost increases must be
documented and approved by Buyer.

     5.  Product Prices. The OEM Prices and volume earned discounts are as shown
in Exhibit E. [****]  Seller and Buyer agree  to renegotiate prices and
discounts as necessary or appropriate to respond to market conditions.  After
eighteen months from the Effective date of this Agreement, Exhibit E may be
modified from time to time upon sixty (60) days written notice from the Seller;
provided, however, that Buyer may terminate this Agreement within thirty (30)
days after receipt of notice of such price increase if such increase is
unacceptable to Buyer.  Seller agrees and acknowledges that should such prices
exceed the lowest Product prices provided to any other customer of Seller
purchasing Product at similar (or reduced) volume levels and making only similar
or reduced commitments (including, but not limited to time commitments), such
prices to Buyer shall be automatically adjusted to reflect any lower pricing
provided to such other customers.

     6.  Product Training and Support.

         a. In order to provide sufficient warranty support for the Product,
Buyer's service training personnel will successfully complete Seller's certified
training course in order to become competent to a level equivalent to Seller's
certified service technicians. Seller shall provide such training for up to five
(5) scheduled classes and for a maximum of ten (10) students per class. Such
training shall be given at Seller's facilities free of charge for the first five
scheduled classes of the term of this Agreement and at Seller's published prices
for any remaining training. Buyer shall be responsible for its own travel
expenses as incurred for such training at Seller's facilities.

         b. Seller will provide sales and marketing support to Buyer's key
dealers, as requested and identified by Buyer and agreed to by the Seller.

     7.  Term.  The initial term of this Agreement shall be Five (5) years,
commencing as of January 1, 2000 (the "Effective Date").  This Agreement shall
automatically be extended for additional terms of six (6) months each unless
either party gives written notice to terminate at least three (3) months prior
to the end of the initial term or any additional term, or unless otherwise
terminated pursuant to the provisions hereof.

     8.  Warranty.

         a. Seller warrants that each Product shall be in conformity with
the Specifications and shall be free from defects in material and workmanship.
In addition, any hardware, software or firmware provided by Seller to Buyer is
warranted to accurately process properly formatted date/time data (including,
but not limited to, calculating, comparing, and sequencing) from, into, and
between the twentieth and twenty-first centuries, and the years 1999 and 2000
and leap year calculations to the extent

                                      B-2

***Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.***

<PAGE>

that other hardware, software or firmware used in combination with the hardware,
software or firmware being provided by Seller, properly exchanges properly
formatted date/time data with it.

         b. Except as provided below, Seller will provide Buyer with the same
warranty, under the same terms and conditions (including without limitation,
disclaimers), as Buyer provides to its customers procuring electric power
generation products (as attached as Exhibit G); provided, however, that Seller's
warranty to Buyer shall be for a one year period from the date of delivery to
the end-user, notwithstanding any longer warranty period in Buyer's warranty. If
Buyer performs travel labor (up to four hours), Seller shall reimburse such
documented, customary and reasonable expenses incurred by Buyer on behalf of the
Product provided such labor is performed by an employee of Buyer or one of its
dealers that has been competently trained with respect to the Product. A
quarterly written statement of Buyer's actual costs for providing warranty
services to its customers, including notice of specific Product failures, and
summary information on the causes of such failure, will be sent by Buyer to
Seller.

         c. Within twelve (12) months from the Effective Date of this Agreement,
Buyer shall inventory and maintain appropriate spares to provide its standard
level of service.

         d. Claims for Buyer's "Product Improvement Programs" (PIP), "Product
Support Programs" (PSP), "Extended Warranty" and other policy actions are to be
negotiated on a case-by-case basis by both parties and documented in writing as
signed by both parties. Participation in these programs will be based on an
amount mutually agreed to by Seller and Buyer.

     THE FOREGOING WARRANTIES SHALL BE SELLER'S SOLE LIABILITY WITH REGARD TO
THE PRODUCTS.

     9.  Indemnification.  Except to the extent covered by the indemnity from
Buyer below, Seller agrees to indemnify, defend, and hold Buyer harmless against
and from all claims, demands, liabilities, loss, damage, cost, and expense, of
whatsoever nature paid to a third party or incurred in the defense (i) arising
from a claim that the Product infringes an intellectual property right of a
third party or (ii) arising from the injury or death of any person or loss or
damage to property directly due to, any defect of design, material, or
workmanship of Product  or failure of Product  to conform with the
Specifications, provided Seller is promptly notified of any and all such
threats, claims or proceedings related thereto and given reasonable assistance
and the opportunity to assume sole control over defense and settlement; Seller
shall not be responsible for any settlement it does not approve of in writing.
The indemnity provided in this Section shall be Buyer's sole and exclusive
remedy for any claim of infringement related to the Product.  Buyer agrees to
indemnify, defend, and hold Seller harmless against and from all claims,
demands, liabilities, loss, damage, cost, and expense, of whatsoever nature paid
to a third party or incurred in the defense of a claim arising on account of
Buyer's (i) misrepresentation of the Product or providing unauthorized
representations or warranties to its customers, (ii) modifications to the
Product or (iii) negligence or other fault of products or services of Buyer.

     10.  Indemnity Restrictions.  SELLER MAKES NO WARRANTY OR REPRESENTATION
WITH RESPECT TO, (a) determining whether the Product will achieve the results
desired by Buyer or any third person, (b) selecting, procuring, installing,
operating and maintaining complementary equipment to insure correct operation of
the Product, and (c) ensuring the accuracy of any configuration design or
implementation that utilizes the Product.  In the event of any alteration or
attachment to the Product not authorized by Seller, Seller shall have no
liability or responsibility to Buyer for:  (a) any hardware, software,
equipment, or services provided by any persons other than Seller; (b) the proper
functioning of the Product if the alteration or attachment is the cause of the
malfunction; or (c) damage caused by any alteration or attachment to the
Product.

                                      B-3
<PAGE>

     11.  Insurance.  Seller agrees to keep in full force and effect, at its
sole expense, during the term of this Agreement and for a period of ten (10)
years thereafter, at least the insurance coverage described below with insurance
companies acceptable to Buyer.  The limits set forth are minimum limits and
shall not be construed to limit Seller's liability.  All cost and deductible
amounts shall be for the sole account of Seller.  All policies required by Buyer
pursuant to this Agreement shall name Buyer as an additional insured (per ISO
Endorsement #CG 2026 or its equivalent) and waive subrogation rights in favor of
Caterpillar.  All policies required shall also be designated as primary coverage
to any similar coverage carried by Caterpillar.

     Seller shall not provide Product hereunder until all insurance as required
hereunder has been obtained, and certificates have been submitted to and
accepted by Buyer.

     The required coverage shall be:  Commercial General Liability Insurance
(Occurrence Coverage) including products, completed operations, contractual
liability coverage of indemnities contained in this contract, with a minimum
combined single limit of liability of $5,000,000 for each occurrence for bodily
injury and property damage.  Such policy shall contain provisions that provide
at least thirty (30) days prior written notice of any cancellation, non-renewal,
or reduction in coverage to Buyer.  Seller shall deliver Certificates of
Insurance in a form satisfactory to Buyer evidencing the existence of such
policy.

     12.  Termination by Buyer.  Buyer may terminate this Agreement at any time,
in the event:

         a. Quality - Products consistently and materially fail to meet the
Specifications as defined herein or as hereafter agreed to by Buyer and Seller,
or fails to achieve status as a Caterpillar certified supplier within twenty-
four (24) months of the Effective Date of this Agreement.

         b. Delivery - Seller is substantially and continuously failing to meet
Buyer's Firm Orders with respect to mutually agreed shipment dates. Seller shall
provide to Buyer a written schedule of Seller's standard lead times for delivery
of Products from the date Orders are accepted by Seller. Such schedule for lead
times shall be updated by Seller on a regular basis to reflect any modifications
thereto.

         c. Competitiveness - Seller fails to be responsive to the market place
or fails to remain competitive on a world-wide basis with other manufacturers of
comparable parts in terms of price.

         d. Default Generally - Material default by Seller in any material
obligation hereunder owed by Seller to Buyer.

     Notwithstanding the above, Buyer may terminate pursuant to Subsections (a),
(b), (c) or (d) above only if Seller has failed to cure such default within
sixty (60) days after written notice thereof has been received by Seller.

     13.  Termination by Seller.  Seller may terminate this Agreement at any
time in the event Buyer breaches the Agreement and fails to cure such breach
within sixty (60) (or ten days in the case of non-payment) after written notice
thereof has been received by Buyer.

     14.  Licenses.  As between the parties, Seller shall own all right, title
and interest in and to the Product except as otherwise provided in the "Phase II
Development and Phase III Feasibility Study Agreement.".  In the event that this
Agreement is terminated by Buyer pursuant to Section 12(b) and only while Buyer
remains in full compliance with the provisions of this Agreement prior to
termination and

                                      B-4
<PAGE>

 following termination as such surviving provisions shall apply, Seller hereby
grants to Buyer, effective as of such termination date, a nonexclusive,
worldwide, royalty bearing license (including the right to sublicense to Buyer's
Affiliates) to make, have made, use and/or sell Product. The foregoing license
shall only be effective for the 18 months beginning with the date of termination
and Buyer shall pay a royalty of one thousand two hundred fifty dollars ($1,250)
per delivered megajoule per published rating by Seller for each Product.

     Each of Buyer and Seller grant to the other party an irrevocable,
perpetual, nonexclusive, worldwide, royalty free license (including the right to
sublicense to such other party's Affiliates) to make, have made, use, sell and
otherwise exploit during the term of this Agreement any modifications,
improvements, inventions, know how, ideas or suggestions made with respect to
the other party's Confidential Information by such party's employees who have
had access to such Confidential Information.  If something ceases to be
considered Confidential Information, licenses granted with respect thereto while
such information was deemed Confidential Information will be unaffected.

     15.  Parts Support.  During the term of this Agreement or following any
termination hereof, other than termination by Seller due to a breach by Buyer,
Seller shall provide, or at its option cause to be provided, such quantities of
parts to Buyer as Buyer may request from time to time for a period of five (5)
years from the date of the last customer shipment made by Seller under this
Agreement of the applicable Product release, at a price not to exceed Seller's
then-current prices provided to other customers under similar terms and
conditions, provided such parts are reasonably and commercially available to
Seller.  If for any reason Seller is unable to provide parts to Buyer pursuant
to its obligations under this section 14, Seller grants to Buyer a nonexclusive,
perpetual, worldwide royalty bearing license to make, have made, use and/or sell
such parts utilizing Seller's proprietary designs.  The foregoing license is
subject to a royalty of 6% of the applicable price set forth in Seller's most
current Catalog Spares Pricing list.

     16.  Use of Other Supply Sources.  Nothing in this Agreement shall prevent
Buyer from seeking other sources for alternatives to the Product to the extent
Seller's production capacity continuously and substantially fails to meet
Buyer's Firm Orders.

     17.  Change in Ownership and Control.  During the life of this Agreement,
if there is a change in the ownership and control of either party, the other
party shall have the option of terminating this Agreement immediately by giving
written notice thereof within ten days of being notified of the occurrence of
such change of control; provided that if a party provides advance notice of a
bona fide proposed change of control (including the identity of the principal
owners after such change of control occurs) the other party will within ten days
provide written notification to the first party as to whether it will exercise
such termination right if the change of control occurs.  For purposes of this
Section 17, a change in the ownership and control of either Buyer or Seller or a
parent company of either party shall be deemed to have occurred if and only if
and when any one or more persons (excluding existing investors) acting in
concert individually or jointly is or becomes a beneficial owner, directly or
indirectly, of securities representing more than fifty percent (50%) of the
combined voting power of all then outstanding securities of Seller or Buyer or
the parent company of either party.

     18.  Shipping Instructions/Terms and Conditions.  Orders will be placed
under Buyer's blanket purchase order(s).  This agreement shall supersede Buyers
standard purchase order terms (other than the terms under the following
sections:  "Work on Buyer's Premises" and "Property Furnished to Seller by
Buyer", which terms shall be deemed to be incorporated herein by reference and
made a part hereof) or any terms stated in any acknowledgment forms or other
forms utilized by Seller or Buyer.  Such orders shall specify the quantity, part
number and description, unit price, requested ship date, destination, and
Buyer's freight carrier and account number with the carrier.  Orders shall be
subject to acceptance by Seller ("Firm Orders").  No modification to this
Agreement will be stated on an order.  All

                                      B-5
<PAGE>

Products shall be shipped F.O.B. Seller's facility in Austin, Texas. Title and
risk of loss to Product shall pass to Buyer upon delivery to the carrier at the
F.O.B. point. Buyer shall designate a carrier. Any special freight charges shall
be Seller's responsibility if necessary to meet not more than 115% of Buyer's
projected quarterly requirements.

     19.  Inspection.  Product is subject to Buyer's inspection, testing and
approval.  Buyer, at its option, may reject or refuse to accept any Product
which does not meet the requirements of the warranty set forth herein.  Buyer's
right to reject shall expire one (1) year after the date of shipment.  Prior to
returning any Product, Buyer shall notify Seller of its intent to reject, and
Seller may within thirty (30) days correct any such defect.  Items rejected by
Buyer will be returned to Seller at Seller's expense, and Seller agrees to
refund to Buyer any payments (including but not limited to shipment expense)
made by Buyer for such Product.  Payment by Buyer for any Product shall not be
deemed an acceptance thereof.  Acceptance of any Product shall not relieve
Seller from any of its obligations, representations or warranties hereunder or
with respect thereto.

     20.  Prices and Payments.  Prices set forth in Exhibit E do not include
installation, freight and handling charges, or applicable taxes, and Buyer shall
be responsible for all such charges and taxes with respect to the Products and
the shipment thereof.  All payments shall be made by Buyer  in accordance with
the terms of Buyer's then-current standard settlement schedule.  All payments
due hereunder shall be paid to Seller in United States dollars in the United
States.  Unless Buyer furnishes a proper exemption certificate, Buyer shall be
charged for all taxes, however, designated, levied or based on this Agreement or
the Product.

     21.  Force Majeure.  Neither Buyer nor Seller shall be liable for any delay
in or failure of performance of their respective obligations hereunder if such
performance is rendered impossible or impracticable by reason of fire,
explosion, earthquake, accident, breakdown, strike, drought, embargo, war, riot,
act of God or public enemy, an act of governmental authority, agency or entity,
shortage of raw materials, or other contingency, delay, failure or cause, beyond
the reasonable control of the party whose performance is affected, irrespective
of whether such contingency is specified herein or is presently occurring or
anticipated by either party.  Upon the occurrence of any event covered by this
provision, Seller and Buyer shall make every effort to continue to maintain as
much as possible the supplier-customer relationship established under this
Agreement.  However, in the event Buyer or Seller is unable to meet its
obligations hereunder because of the conditions described above and such
inability continued for a period of two (2) months, the other party shall have
the right to terminate this Agreement upon thirty (30) days prior written
notice.

     22.  Assignment/Applicable Law.  Except to an entity that acquires all or
substantially all the business or assets of a party, this Agreement is not
assignable by either party without the written consent of the other party and
will be governed by and construed in accordance with the laws of the State of
New York without regard to the conflict of laws provisions thereof.

     23.  Entire Agreement.  This Agreement and the Exhibits hereto constitute
the entire agreement and understanding between the parties with respect to the
subject matters herein and therein, and supersede and replace any prior
agreements and understandings whether oral or written, between them with respect
to such matters.  Without limiting the generality of the foregoing, it is
understood that this Agreement supersedes and replaces the Phase II Purchase
Agreement Terms and Conditions attached as Exhibit B to the Phase II Development
and Phase III Feasibility Study Agreement dated as of January 22, 1999.  Any
additional or different terms of any related purchase order, confirmation,
acknowledgment, shipping instruction form or similar form of Buyer or Seller
even if signed by the parties after the date hereof, shall have no force or
effect.

                                      B-6
<PAGE>

     24.  Waiver.  The provisions of this Agreement may waived, altered,
amended, or repealed in whole or in part upon the written consent of all parties
to this Agreement The waiver by party of any breach of this Agreement shall not
be deemed or construed as a waiver of any other breach, whether prior,
subsequent or contemporaneous, of this Agreement.

     25.  Severability.  Invalidation of any of the provisions contained herein,
or the application of such invalidation of thereof to any person, by
legislation, judgment or court order shall in no way affect any of the other
provisions hereof or the application thereof to any other person, and the same
shall remain in full force and effect, unless enforcement as so modified would
be unreasonable or grossly inequitable under all the circumstances or would
frustrate the purposes hereof.

     26.  Counterparts.  Section headings contained herein are for ease of
reference only and shall not be given substantive effect.  This Agreement may be
signed in one or more counterparts, each to be effective as an original.

     27.  Limitation of Liability.  NEITHER PARTY SHALL BE LIABLE FOR ANY
SPECIAL, INCIDENTAL, INDIRECT OR CONSEQUENTIAL DAMAGES ARISING OUT OF THE
SUBJECT MATTER OF THIS AGREEMENT, OR BUYER'S COST OF PROCUREMENT OF SUBSTITUTE
GOODS OR SERVICES.

     28.  Confidential Information.

          a.  In connection with work under this Agreement, a party
("TRANSMITTING PARTY") may deliver PROPRIETARY INFORMATION relating directly to
the business or technology of the other party ("RECEIVING PARTY").  The
RECEIVING PARTY may not use PROPRIETARY INFORMATION except as necessary to
perform its obligations under this Agreement, will protect the confidentiality
of the PROPRIETARY INFORMATION with at least the same degree of care as it
protects its own confidential information and will not disclose any such
PROPRIETARY INFORMATION, without the express written consent of the TRANSMITTING
PARTY.  "PROPRIETARY INFORMATION" includes any process, system, formula,
pattern, model, device compilation, or information:  (i) not known by the
RECEIVING PARTY prior to this Agreement or known by the RECEIVING PARTY prior to
this Agreement but having restriction on its use or disclosure; and (ii) not
generally known by others (unless so know through some fault of the RECEIVING
PARTY).  PROPRIETARY INFORMATION does not include knowledge, skills or
information which is generally known in Seller's or Buyer's trade or profession.

          b.  Each party agrees that it will neither (i) disclose to the other
party or any of its employees information in confidence belonging to a third
party; nor (ii) knowingly in the performance of the work hereunder produce
anything that embodies information under confidential restriction, or is covered
by a patent, patent application, copyright, trade secret, or other intellectual
property right owned by a third party.

          c.  Nothing in this Agreement shall be construed as preventing either
party from independent development, provided that the PROPRIETARY INFORMATION is
handled in accordance with paragraph 28(a).

          d.  Should the RECEIVING PARTY be required to disclose PROPRIETARY
INFORMATION by governmental or judicial order, the RECEIVING PARTY will give the
TRANSMITTING PARTY prompt notice of any such order and will comply with any
protective order imposed on such disclosure.

                                      B-7
<PAGE>

     29.  Compliance with Laws.  Both parties represent that they have complied,
and during the performance of this Agreement will continue to comply, with the
provisions of all applicable laws and regulations from which liability may
accrue to the other party for any violation thereof.

     30.  Confidentiality.  Except with respect to potential investors and/or
acquirers, the terms of this Agreement as well as its existence shall be kept
confidential and not disclosed by either party without the express written
consent of the other party.


Caterpillar, Inc.                       Active Power, Inc.

By:  /s/                                By::      /s/
   ----------------------                   -----------------------
 Name:                                   Name:
 Title:                                  Title:

                                      B-8
<PAGE>

                                  EXHIBIT "A"

                         PHASE II MARKETING ACTIVITIES


 .  Buyer will conduct a product launch with appropriate marketing subsidiaries
   and dealers.
 .  Buyer will create appropriate sales binder for above training or launch.
 .  Buyer will effect pricing and price list literature for the program for all
   appropriate worldwide marketing subsidiaries and dealers.
 .  Buyer will announce product to dealers.
 .  Buyer will effect a Caterpillar Product News announcement.
 .  Buyer will create product brochures for product promotion.
 .  Buyer will create product specification sheets.
 .  Buyer will enter appropriate performance and specifications into its online
   Technical Marketing Information (TMI) systems.
 .  Buyer will make adequate technical drawings available to its dealers.
 .  Buyer will effect a public product announcement of the phase II product that
   will include reference to the new Caterpillar UPS product and its use of the
   Active Power flywheel energy storage system.
 .  Buyer will create a product promotional video.
 .  Buyer will include the product where appropriate in its
   marketing/specification software.
 .  Buyer will promote the product internally to its worldwide marketing
   subsidiaries.
 .  Buyer will effect the above in all languages deemed appropriate by Buyer.

   Implementation of the foregoing Marketing Activities is dependent upon Buyer
   receiving adequate product and technical information from Seller

                                      B-9
<PAGE>

                                  EXHIBIT "B"

                                   FORECAST

                   (to be provided as of the Effective Date)

                                     B-10

<PAGE>

                                  EXHIBIT "C"


                            BUYER'S COMPETITOR LIST

                                    [****]



                                     B-11

***Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.***
<PAGE>

                                  EXHIBIT "D"

                  MINIMUM PURCHASE COMMITMENT OVER FIVE YEARS

                                    [****]


                                     B-12

***Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.***
<PAGE>

                                  EXHIBIT "E"

                                    [****]


                                     B-13

***Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.***
<PAGE>

                                   EXHIBIT G

      Effective with sales to the first user on or after January 1, 2000

                         CATERPILLAR LIMITED WARRANTY
                        INDUSTRIAL ENGINE PRODUCTS AND
                      ELECTRIC POWER GENERATION PRODUCTS
                                  WORLDWIDE*

              (*excluding the Commonwealth of Independent States)

Caterpillar Inc. or any of its subsidiaries ("Caterpillar") warrants new and
Remanufactured engines and electric power generation products sold by it
(including any products of other manufacturers packaged and sold by Caterpillar)
and operating outside the Commonwealth of Independent States (formerly USSR), to
be free from defects in material and workmanship.

A different warranty statement applies to product operating in the Commonwealth
of Independent States. Copies of this warranty may be obtained by writing
Caterpillar Inc., 100 N.E. Adams St., Peoria, IL USA 61629-9260.

This warranty does not apply to CM product, engines sold for use in on-highway
vehicle or marine applications, engines in machines manufactured by or for
Caterpillar, 3500 and 3600 Family engines used in locomotive applications, 3000
Family engines, or Caterpillar brand batteries. These products are covered by
other Caterpillar warranties.

This warranty is subject to the following:

WARRANTY PERIOD

The warranty period for new engines, Uninterruptible Power Systems (UPS
systems), and electric power generation products is 12 months (24 months for
mobile agricultural and standby electric power generation applications) after
date of delivery to the first user.

The warranty period for all Remanufactured engines is 6 months (12 months for
mobile agricultural and standby electric power generation applications) after
date of delivery to the first user.

CATERPILLAR RESPONSIBILITIES

If a defect in material or workmanship is found during the warranty period,
Caterpillar will, during normal working hours and through a place of business of
a Caterpillar dealer or other source approved by Caterpillar:

 . Provide (at Caterpillar's choice) new, Remanufactured or Caterpillar-approved
  repaired parts or assembled components needed to correct the defect.

Note:  Items replaced under this warranty become the property of Caterpillar.

 . Replace lubricating oil, filters, coolant and other service items made
  unusable by the defect.

 . Provide reasonable or customary labor needed to correct the defect, including
  labor to disconnect the product from and reconnect the product to its attached
  equipment, mounting, and support systems, if required.

For new 3114, 3116 and 3126 engines and electric power generation products
(including any new products of other manufacturers packaged and sold by
Caterpillar):

 . Provide travel labor, up to four hours round trip if, in the opinion of
  Caterpillar, the product cannot reasonably be transported to a place of
  business of a Caterpillar dealer or other source approved by Caterpillar
  (travel labor in excess of four hours round trip, and any meals, mileage,
  lodging, etc. is the user's responsibility).

For all other products:

 . Provide reasonable travel expenses for authorized mechanics, including meals,
  mileage, and lodging, when Caterpillar chooses to make the repair on-site.

USER RESPONSIBILITIES

The user is responsible for:

 . Providing proof of the delivery date to the first user.

 . Labor costs, except as stated under "Caterpillar Responsibilities", including
  costs beyond those required to disconnect the product from and reconnect the
  product to its attached equipment, mounting and support systems.

 . Travel expenses not covered under "Caterpillar Responsibilities".

 . All costs associated with transporting the product to and from the place of
  business of a Caterpillar dealer or other source approved by Caterpillar.

 . Premium or overtime labor costs.

 . Parts shipping charges in excess of those which are usual and customary.

 . Local taxes, if applicable.

 . Costs to investigate complaints, unless the problem is caused by a defect in
  Caterpillar material or workmanship.

 . Giving timely notice of a warrantable failure and promptly making the product
  available for repair.

 . Performance of the required maintenance (including use of proper fuel, oil,
  lubricants and coolant) and items replaced due to normal wear and tear.

 . Allowing Caterpillar access to all electronically stored data.

                                        (continued on reverse side...)

<PAGE>

                                   EXHIBIT G

LIMITATIONS

Caterpillar is not responsible for:

 . Failures resulting from any use or installation which Caterpillar judges
  improper.

 . Failures resulting from attachments, accessory items and parts not sold or
  approved by Caterpillar.

 . Failures resulting from abuse, neglect and/or improper repair.

 . Failures resulting from user's delay in making the product available after
  being notified of a potential product problem.

 . Failures resulting from unauthorized repair or adjustments, and unauthorized
  fuel setting changes.

 . Damage to parts, fixtures, housings, attachments, and accessory items which
  are not part of the engine or electric power generation product (including any
  products of other manufacturers packaged and sold by Caterpillar).

 . Repair of components sold by Caterpillar that are warranted directly to the
  user by their respective manufacturer. Depending on type of application,
  certain exclusions may apply. Consult your Caterpillar dealer for more
  information.

For products operating outside of Australia, Fiji, Nauru, New Caledonia, New
Zealand, Papua New Guinea, the Solomon Islands and Tahiti, the following is
applicable:

NEITHER THE FOREGOING EXPRESS WARRANTY NOR ANY OTHER WARRANTY BY CATERPILLAR,
EXPRESS OR IMPLIED, IS APPLICABLE TO ANY ITEM CATERPILLAR SELLS WHICH IS
WARRANTED DIRECTLY TO THE USER BY ITS MANUFACTURER.

THIS WARRANTY IS EXPRESSLY IN LIEU OF ANY OTHER WARRANTIES, EXPRESS OR IMPLIED,
INCLUDING ANY WARRANTY OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE,
EXCEPT CATERPILLAR EMISSION-RELATED COMPONENTS WARRANTIES FOR NEW ENGINES, WHERE
APPLICABLE. REMEDIES UNDER THIS WARRANTY ARE LIMITED TO THE PROVISION OF
MATERIAL AND SERVICES, AS SPECIFIED HEREIN. CATERPILLAR IS NOT RESPONSIBLE FOR
INCIDENTAL OR CONSEQUENTIAL DAMAGES.

CATERPILLAR EXCLUDES ALL LIABILITY FOR OR ARISING FROM ANY NEGLIGENCE ON ITS
PART OR ON THE PART OF ANY OF ITS EMPLOYEES, AGENTS OR REPRESENTATIVES IN
RESPECT OF THE MANUFACTURE OR SUPPLY OF GOODS OR THE PROVISION OF SERVICES
RELATING TO THE GOODS.

IF OTHERWISE APPLICABLE, THE VIENNA CONVENTION (CONTRACTS FOR THE INTERNATIONAL
SALE OF GOODS) IS EXCLUDED IN ITS ENTIRETY.

For electric power generation products sold for personal or family use,
operating in the USA, its territories and possessions, some states do not allow
limitations on how long an implied warranty may last nor allow the exclusion or
limitation of incidental or consequential damages. Therefore, the previously
expressed exclusion may not apply to you. This warranty gives you specific legal
rights and you may also have other rights which vary by jurisdiction. To find
the location of the nearest Caterpillar dealer or other authorized repair
facility, call (800) 447-4986. If you have questions concerning this warranty or
its applications, call or write:

In USA and Canada:  Caterpillar Inc., Engine Division, P.O. Box 610, Mossville,
IL 61552-0610, Attention:  Customer Service Manager, Telephone (800) 447-4986.
Outside the USA and Canada:  Contact your Caterpillar dealer.

For products operating in Australia, Fiji, Nauru, New Caledonia, New Zealand,
Papua New Guinea, the Solomon Islands and Tahiti, the following is applicable:

THIS WARRANTY IS IN ADDITION TO WARRANTIES AND CONDITIONS IMPLIED BY STATUTE AND
OTHER STATUTORY RIGHTS AND OBLIGATIONS THAT BY ANY APPLICABLE LAW CANNOT BE
EXCLUDED, RESTRICTED OR MODIFIED ("MANDATORY RIGHTS"). ALL OTHER WARRANTIES OR
CONDITIONS, EXPRESS OR IMPLIED (BY STATUTE OR OTHERWISE), ARE EXCLUDED.

NEITHER THIS WARRANTY NOR ANY OTHER CONDITION OR WARRANTY BY CATERPILLAR,
EXPRESS OR IMPLIED (SUBJECT ONLY TO THE MANDATORY RIGHTS), IS APPLICABLE TO ANY
ITEM CATERPILLAR SELLS WHICH IS WARRANTED DIRECTLY TO THE USER BY ITS
MANUFACTURER.

TO THE EXTENT PERMITTED UNDER THE MANDATORY RIGHTS, IF CATERPILLAR IS THE
SUPPLIER TO THE USER, CATERPILLAR'S LIABILITY SHALL BE LIMITED AT ITS OPTION TO
(a) IN THE CASE OF SERVICES, THE SUPPLY OF THE SERVICES AGAIN OR THE PAYMENT OF
THE COST OF HAVING THE SERVICES SUPPLIED AGAIN, AND (b) IN THE CASE OF GOODS,
THE REPAIR OR REPLACEMENT OF THE GOODS, THE SUPPLY OF EQUIVALENT GOODS, THE
PAYMENT OF THE COST OF SUCH REPAIR OR REPLACEMENT OR THE ACQUISITION OF
EQUIVALENT GOODS.

CATERPILLAR EXCLUDES ALL LIABILITY FOR OR ARISING FROM ANY NEGLIGENCE ON ITS
PART OR ON THE PART OF ANY OF ITS EMPLOYEES, AGENTS OR REPRESENTATIVES IN
RESPECT OF THE MANUFACTURE OR SUPPLY OF GOODS OR THE PROVISION OF SERVICES
RELATING TO THE GOODS.

CATERPILLAR IS NOT LIABLE FOR INCIDENTAL OR CONSEQUENTIAL DAMAGES UNLESS IMPOSED
UNDER MANDATORY RIGHTS.

IF OTHERWISE APPLICABLE, THE VIENNA CONVENTION (CONTRACTS FOR THE INTERNATIONAL
SALE OF GOODS) IS EXCLUDED IN ITS ENTIRETY.

This warranty covers every major component of the products. Claims under this
warranty should be submitted to a place of business of a Caterpillar dealer or
other source approved by Caterpillar. For further information concerning either
the location to submit claims or Caterpillar as the issuer of this warranty,
write Caterpillar Inc., 100 N. E. Adams St., Peoria, IL USA 61629-9260, or its
subsidiary, Caterpillar of Australia Ltd., 1 Caterpillar Drive, Private Mail Bag
4, Tullamarine, Victoria 3043, Australia.
<PAGE>


                                  EXHIBIT "C"

                              PAYMENT MILESTONES


<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------------
               MILESTONE                                     PAYMENT                     ESTIMATED
               ---------                                     -------                     ---------
                                                                                         COMPLETION
                                                                                         ----------
                                                                                            DATE
                                                                                            ----
---------------------------------------------------------------------------------------------------------
<S>                                                      <C>                        <C>
1.  Phase II agreement signed                                  $ .5 million                  4Q98

---------------------------------------------------------------------------------------------------------
1.  CS-UPS bench demo at Active Power's
    Austin facility that meets following                       $1.0 million                  1Q99
    performance objectives:

 . 30 second discharge at 50 kW
 . flywheel recharges in less than 20 minutes
 . less than 15% THD on input & output
 . output voltage regulation plus or minus 10%
---------------------------------------------------------------------------------------------------------
3.  CS-UPS bench demo at Active Power's                        $1.5 million                  1Q99
    Austin facility that meets following
    performance objectives:

 . 20 second discharge at 100 kW
 . flywheel recharges in less than 10 minutes
 . less than 10% THD on input & output
 . output voltage regulation plus or minus 5%
---------------------------------------------------------------------------------------------------------
4.  CS-UPS bench demo at Active Power's                        $1   million                  2Q99
    Austin facility that meets following
    performance objectives:

 . will use production components
 . single board controller for flywheel & UPS
 . static switch & contactors operational
 . 12.5 second discharge at 250 kW
 . flywheel recharges in less than 5 minutes
 . less than 5% THD on input & output
 . output voltage regulation plus or minus 2%
---------------------------------------------------------------------------------------------------------
5.  Phase II product meets Exhibit A                            $1  million                  3Q99
    specifications and first Phase II unit
    shipped, along with associated production
    drawings, to Caterpillar.
---------------------------------------------------------------------------------------------------------
</TABLE>

<PAGE>


                                  EXHIBIT "D"

                         CATERPILLAR'S COMPETITOR LIST

                                    [****]

***Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.***


<PAGE>


                                  EXHIBIT "E"

            PICTORIAL DESCRIPTION OF PROGRAM INTELLECTUAL PROPERTY

                              PHASE II SCHEMATIC

                            [Graphic of Schematic]

[Description of graphic: The schematic depicts the elements of each party's
intellectual property divided between "flywheel and flywheel electronics" and
"UPS electronics."]

For the avoidance of doubt, PROGRAM INTELLECTUAL PROPERTY does not include
INTELLECTUAL PROPERTY with respect to the fly wheel, fly wheel electronics or
flywheel packaging.