This IS a tough spot to be in, but I think you are correct in that you need to quit trying to counsel her spiritually. That is what her pastor is for.
If I were in your shoes, I would --in confidence--call the pastor (you've spoken with him before, right?) and let him know you are thrilled that she has decided to be baptized, but you are concerned that she also seems to believe that this gives her license to sin, and because of God's grace, it will all be OK. Perhaps some additional pre-baptismal counselling by the pastor would be a good idea.
Let the pastor know that you and the children plan to be there to support her. Arrive early and sit in front. I think it would be a mistake to miss her baptism. Just my thoughts...
