Exhibit 10.23

PHASE III PRODUCT DEVELOPMENT AGREEMENT

This DEVELOPMENT AGREEMENT ("Agreement") is
      effective as of September 1, 2001 ("Effective Date"), by and between Active
      Power, 11525 Stonehollow Drive, Suite 110, 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 III 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 (identified as PROGRAM INTELLECTUAL PROPERTY in the box on
      the right side of Exhibit E to this Agreement).ACTIVE POWER agrees to
      review with CATERPILLAR prior to ACTIVE POWER developing any product rated
      below 300kVA that uses PROGRAM INTELLECTUAL PROPERTY, as shown in Exhibit
      E.

f)
         "PROGRAM" shall mean the efforts of CATERPILLAR or ACTIVE
      POWER to develop PHASE III PRODUCTS.PHASE III PRODUCTS are those products
      identified as such in Exhibit E to the Phase II and Phase III Purchase
      Agreement and expressly do not include any product rated at less than 300 kVA.

2.   PROGRAM

This Agreement governs Phase III
      development. Notwithstanding anything contained in this Agreement and subject
      to the restrictions in the PHASE I Purchase Agreement and PHASE II & Phase
      III Purchase Agreement, nothing contained herein shall preclude ACTIVE POWER
      from selling or otherwise disposing of products other than PHASE II OR PHASE
      III PRODUCTS.

EXHIBIT 10.23

a)
         PHASE III

(i)
         The parties shall cooperate to develop PHASE III PRODUCT
      as defined on Exhibit E to the Phase II & Phase III Purchase
      Agreement.  ACTIVE POWER shall be responsible for the design and
      development of the PHASE III PRODUCT, except that CATERPILLAR shall be
      responsible for the design and development of [****]. The PHASE III
      PRODUCT specification and requirements are detailed in Exhibit A
      ("Specifications").

(ii)
         The parties will cooperate with one another to design,
      develop and test the PHASE III 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 III PRODUCT prototype within sixty (60) 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 III 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 III 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 III prototype and the
      acceptance/rejection/correction provisions above shall be reapplied until the
      PHASE III 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 III 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
      III 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 III PRODUCTS
      pursuant to the provisions of the Phase II & Phase III Purchase Agreement
      specified in Exhibit B hereto. In the event of conflict between this
      Agreement and the Phase II & Phase III Purchase Agreement, this Agreement
      shall control. Caterpillar may exercise such Phase III 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.

3.   PHASE III 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.

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** 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.**

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 ("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.

d)
         ACTIVE POWER will contribute at least $5,000,000 in kind to
      the design, development and testing of the PHASE III PRODUCT, as shown in
      quarterly reports and documents to CATERPILLAR. CATERPILLAR may suspend
      its payments if such quarterly reports and documents are not of sufficient
      detail to allow CATERPILLAR to reasonably ascertain the specifics of such
      ACTIVE POWER contributions, including amounts of payments and descriptions of
      work performed.

e)
         ACTIVE POWER will provide quarterly status reports to
      CATERPILLAR relating to the pursuit and achievement of the Milestones.

4.   CONFIDENTIALITY

a)   
      In connection with work under this Agreement, a party ("TRANSMITTING PARTY")
      may deliver PROPRIETARY INFORMATION relating directly to the 
      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).

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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.

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, PROPRIETARY
      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.

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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.

> Notice to ACTIVE POWER: Active Power, Inc. Attn: Bill Kainer
>         11525 Stonehollow Drive, Suite 110  Austin, Texas 78758
>       Notices to CATERPILLAR: Caterpillar Inc.Attn: Purchasing
>         Manager Caterpillar Electric Power  Route 29 - P.O. Box 610 
>         Mossville, Illinois 61552

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 III PRODUCTS shall be
      as set forth in Exhibit B.

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.

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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 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.

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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/ Joseph F. Pinkerton | By: /s/ Jim Parker               
|Name: Joseph F. Pinkerton   | Name: Jim Parker                 
|Title: President & CEO      | Title: Director of Electric Power
|Date: September 12, 2001    | Date: October 18, 2001           
|                            |                                  
|                            |                                  
|                            | CATERPILLAR INC.                 
|                            | By: /s/ Paul Pearson             
|                            | Name: Paul Pearson               
|                            | Title: Purchasing Manager        
|                            | Date: October 12, 2001           

EXHIBIT A

PRELIMINARY SPECIFICATIONS FOR PHASE III PRODUCT

[****]

** 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.**

EXHIBIT B

PURCHASE OF PHASE II & PHASE III PRODUCT TERMS AND CONDITIONS

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

EXHIBIT C

PAYMENT MILESTONES

[****]

** 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.**

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.**

EXHIBIT E

PICTORIAL DESCRIPTION OF PROGRAM INTELLECTUAL PROPERTY

[****]

** 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.**